Markets with Frictions:

Banks
Guido Menzio
University of Pennsylvania, NBER
University of Pennsylvania Fall 2010
Introduction
What is the role of banks in the economy?
i. Many investments are illiquid, in the sense that there is a large
opportunity cost to liquidate the investment before it is completed.
ii. Many households face liquidity risks, in the sense that they may need
consumption before the date at which investments are completed.
iii. The role of banks is to insure households against liquidity risks by
spreading the liquidation costs among households that are able to wait
for the investments to be completed and those who cannot.
Introduction
What is the cause of bank runs?
i. Banks offer more than the liquidation value to households who cannot
wait to consume until investments are completed.
ii. If households fear that a bank will run out of funds before investments
are completed, they will all start withdrawing their funds. Bank runs
disrupt not only the provision of insurance against liquidity risks, but
also the productive side of the economy.
Environment
Technology
Preferences
Environment
Technology
1. There is a constant return to scale long-term technology that turns 1
unit of the good in period 0into y
1
units of the good in period 1and y
2
units of the good in period 2, where:
a. y
1
,y
2
1,0, if production is interrupted in period 1,
b. y
1
,y
2
0,R, R 1, if production is not interrupted in period 1.
T 0 T 1 T 2
1
1
0
0
R
if interrupted
if not interrupted
Environment
Technology
2. There is a constant return to scale short-term technology that turns 1
unit of the good in period T into 1 units of the good in period T 1,
where 0,1.
T 0 T 1 T 2
1
0
1
1
0
1
if used in T 0
if used in T 1
Environment
Preferences
There is a continuumof households with measure 1.
1. Each household is endowed with a unit of the good in T 0.
2. Each household has preferences Uc
1
,c
2
over consumption in T 1,
2. Preferences are subject to a privately observed shock in period 1:
a. with probability t 0,1, Uc
1
,c
2
uc
1
,
b. with probability 1 t, Uc
1
,c
2
uc
2
, 1/R,
c. the utility function uc is s.t. u0 0, u

c 0, u

c 0.
Efficient allocation
The efficient allocation is such that the consumption c
1
for the households
of type 1 and the consumption c
2
for the households of type 2 maximizes
the sumof the households expected utility in period 0, i.e.
max
c
1
,c
2
1 t uc
1
1 t uc
2
.
The choice of c
1
and c
2
is subject to the feasibility constraint
1 t c
2
R1 t c
1
.
Efficient allocation
The efficient allocation is such that the consumption c
1
for the households
of type 1 and the consumption c
2
for the households of type 2 maximizes
the sumof the households expected utility in period 0, i.e.
max
c
1
,c
2
1 t uc
1
1 t uc
2
.
The choice of c
1
and c
2
is subject to the feasibility constraint
1 t c
2
R1 t c
1
.
Remark: In period T 0, all the resources are invested in the long-term
technology because the short-termtechnology is inferior. In period T 1, a
fraction t c
1
of the long-terminvestment is liquidated to finance the
consumption of households of type 1. The remainder of the long-term
investment is left to mature until period 2 and its return is used to finance
the consumption of households of type 2.
Efficient allocation
The Lagrangian of the maximization problemis
L t uc
1
1 t uc
2
R1 tc
1
1 tc
2
.
The first order condition wrt c
1
is
u

c
1

R. (1)
The first order condition wrt c
2
is
u

c
2

. (2)
The first order condition wrt is
1 tc
2

R1 tc
1

. (3)
Efficient allocation
The first order conditions (1) and (2) imply
c
1

c
2

. (4)
The first order condition (3) implies
c

R
1 R 1t
1,R. (5)
Efficient allocation
The first order conditions (1) and (2) imply
c
1

c
2

. (4)
The first order condition (3) implies
c

R
1 R 1t
1,R. (5)
Remarks:
1. In the efficient allocation, households of type 1 and 2 get the same
level of consumption. That is, in the efficient allocation, households are
perfectly insured against the liquidity risk.
Efficient allocation
The first order conditions (1) and (2) imply
c
1

c
2

. (4)
The first order condition (3) implies
c

R
1 R 1t
1,R. (5)
Remarks:
2. In the efficient allocation, the level of consumption for households of
type 1 and 2 lies between the return of the technology in case of
liquidation, 1, and the return of the technology in case the project is
completed, R. The level of consumption is higher when the fraction of
households of type 1 is lower.
Equilibrium without banks
The household chooses consumption conditional on being of type 1, c
1
,
and consumption conditional on being of type 2, c
2
, so as to maximize its
expected utility in period 0, i.e.
max
c
1
,c
2
t uc
1
1 t uc
2
.
The choice of c
1
and c
2
is subject to the feasibility constraints
c
1
1, c
2
R.
Equilibrium without banks
The household chooses consumption conditional on being of type 1, c
1
,
and consumption conditional on being of type 2, c
2
, so as to maximize its
expected utility in period 0, i.e.
max
c
1
,c
2
t uc
1
1 t uc
2
.
The choice of c
1
and c
2
is subject to the feasibility constraints
c
1
1, c
2
R.
Remark: In period T 0, the household invests all its resources in the
long-termtechnology. If the housheold turns out to be of type 1, it liquidates
the entire long-terminvestment and consumes the return. If the housheolds
turns out to be of type 2, it lets the entire long-terminvestment mature and
consumes the return.
Equilibrium without banks
The solution to the maximization problemof the household is
c
1
A
1,
c
2
A
R.
The maximized expected utility of the household is
W
A
t uc
1
A
1 t uc
2
A
.
Equilibrium without banks
The solution to the maximization problemof the household is
c
1
A
1 c

,
c
2
A
R c

.
The maximized expected utility of the household is
W
A
t uc
1
A
1 t uc
2
A

t uc

1 t uc

Equilibrium without banks

The solution to the maximization problemof the household is
c
1
A
1 c

,
c
2
A
R c

.
The maximized expected utility of the household is
W
A
t uc
1
A
1 t uc
2
A

t uc

1 t uc

Remark: In the equilibriumof an economy without banks, the households

expected utility is less than in the efficient allocation because there is no
risk-sharing between the households who can wait to consume until the
investment matures and the households who cannot wait.
Equilibrium with banks
Banks typically offer the following demand deposit contract:
i. Households deposits 1 unit of output in period 0.
ii. Households that withdrawin period 1 get p
1
r if the bank has funds
and p
1
0if the bank has no funds left. The payment is made on a
first-come first-served basis.
iii. Household that withdrawin period 2 get a fraction of the liquidation
value of the banks remaining assets.
Equilibrium with banks
Let denote the fraction of households that withdrawin period 1.
i. If a household withdraws in period 1, it gets
p
1

r, if r 1,
r w.p.
1
r
, 0w.p. 1
1
r
, if r 1.
ii. If a household withdraws in period 2, it gets
p
2

R1 r/1 , if r 1,
0, if r 1.
Equilibrium with banks
If banks offer demand deposit contracts with r c

, there is a good
equilibrium where:
i. Every household of type 1 withdraws in period 1.
ii. Every household of type 2 withdraws in period 2.
Equilibrium with banks
To check that this is in fact an equilibrium, we need to verify that every
household finds it optimal to behave as prescribed by the equilibriumgiven
that all the other households behave as in equilibrium.
1. If other households behave as in equilibrium, then t, p
1
p
2
c

.
2. A household of type 1 finds it optimal to withdrawin period 1 because
up
1
u0.
3. A household of type 2 finds it optimal to withdrawin period 2 because
up
2
up
1
1 .
Equilibrium with banks
In the good equilibrium, consumption of households of type 1 and 2 is
c
1
B
c

, c
2
B
c

.
In the good equilibrium, expected utility of households is
W
B
t uc

1 t uc

.
Equilibrium with banks
In the good equilibrium, consumption of households of type 1 and 2 is
c
1
B
c

, c
2
B
c

.
In the good equilibrium, expected utility of households is
W
B
t uc

1 t uc

.
Remarks:
1. In the good equilibrium, households of type 2 are willing to wait and
withdrawin period 2. This is because, if only households of type 1 are
expected to withdrawin period 1, the banks assets in period 2 are
sufficient to have p
2
p
1
1 .
Equilibrium with banks
In the good equilibrium, consumption of households of type 1 and 2 is
c
1
B
c

, c
2
B
c

.
In the good equilibrium, expected utility of households is
W
B
t uc

1 t uc

.
Remarks:
2. In the good equilibrium, the consumption of households of type 1 and
type 2 is the same as in the efficient allocation. Banks perfectly insure
households against the liquidity risk.
Equilibrium with banks
If banks offer demand deposit contracts with r c

, there is also a bank

run equilibrium where:
i. Every household of type 1 withdraws in period 1.
ii. Every household of type 2 withdraws in period 1.
Equilibrium with banks
To check that this is in fact an equilibrium, we need to verify that every
household finds it optimal to behave as prescribed by the equilibriumgiven
that all the other households behave as in equilibrium.
1. If other households behave according to equilibrium, then 1and
r 1.
2. A household of type 1 finds it optimal to withdrawin period 1 because
1
r
ur 1
1
r
u0 u0.
3. A household of type 2 finds it optimal to withdrawin period 1 because
1
r
u1 r 1
1
r
u0 u0.
Equilibrium with banks
In the bank run equilibrium, consumption of households of type 1 and 2 is
c
1
BR

, w.p. 1/c

0, w.p. 1 1/c

c
2
BR

1 c

, w.p. 1/c

0, w.p. 1 1/c

In the bank run equilibrium, expected utility of households is

W
BR
t
1
c

uc

1
1
c

u0
1 t
1
c

u1 c

1
1
c

u0 W
A
W

.
Equilibrium with banks
Remarks:
1. In the bank run equilibrium, households of type 2 are not willing to wait
and withdrawin period 2. This is because, if all households are
expected to withdrawin period 1, the bank will have no assets left in
period 2.
2. In the bank run equilibrium:
i. households average utility is less than in autarky because
households do not share their liquidity risk and they face the
additional risk of being rationed at the deposit window.
ii. production is lower than in autarky because all investments are
liquidated in period 1.
Suspension of convertibility
In order to avoid runs, banks can offer a demand deposit contract with a
suspension of convertibility clause:
i. Households deposits 1 unit of output in period 0.
ii. Households that withdrawin period 1 get r. The bank suspends the
convertibility of deposits in period 1 after t households withdraw.
iii. Household that withdrawin period 2, get a fraction of the liquidation
value of the banks remaining assets.
Suspension of convertibility
Let denote the fraction of households that withdrawin period 1.
i. If a household withdraws in period 1, it gets
p
1

r, if t,
r w.p.
t

, 0w.p. 1
t

, if t.
ii. If a household withdraws in period 2, it gets
p
2

R1 r/1 , if t,
R1 tr/1 t, if t.
Suspension of convertibility
If banks offer demand deposit contracts with r c

and a suspension of
convertibility clause, there is an equilibriumwhere:
i. Every household of type 1 withdraws in period 1.
ii. Every household of type 2 withdraws in period 2.
Suspension of convertibility
To check that this is in fact an equilibrium, we need to verify that every
household finds it optimal to behave as prescribed by the equilibriumgiven
that all the other households behave as in equilibrium.
1. If other households behave as in equilibrium, then t, p
1
p
2
c

.
2. A household of type 1 finds it optimal to withdrawin period 1 because
up
1
u0.
3. A household of type 2 finds it optimal to withdrawin period 2 because
up
2
up
1
1 .
Suspension of convertibility
Now, we check whether there is a bank run equilibrium where:
i. Every household of type 1 withdraws in period 1.
ii. Every household of type 2 withdraws in period 1.
Suspension of convertibility
To check that this is in fact an equilibrium, we need to verify that every
household finds it optimal to behave as prescribed by the equilibriumgiven
that all the other households behave as in equilibrium.
1. If other households behave according to equilibrium, then 1.
2. A household of type 1 finds it optimal to withdrawin period 1 because
tup
1
1 tu0 u0.
3. A household of type 2 finds it optimal to wait until period 2 because
1
t
up
1
1 1
1
t
up
2
up
2
.
Suspension of convertibility
Remarks:
1. The suspension of convertibility clause guarantees that the bank will
have enough funds to provide consumption c

to households of type 2.
Hence, the clause effectively prevents bank runs
2. The suspension of convertibility clause requires the bank to knowthe
fraction t of households that need to consume in period 1. If the bank
does not knowt, the clause may not be effective at preventing bank
runs. In this case, runs can be prevented if the government steps in as
a lender of last resort.