Joint with F. Allen, I. Goldstein, and A. Leonello
We analyze the trade-offs involved in the introduction of government guarantees in a context where panic and fundamental crises can occur, and both banks' and depositors' decisions are endogenously determined. A scheme against bank illiquidity eliminates panic runs and does not entail any disbursement for the government. By contrast, a scheme protecting depositors also against bank insolvency entails a disbursement for the government and leads to distortions both in the bank's choice of the optimal deposit contract and in government's choice of the optimal guarantees. Yet, we show that the latter scheme may achieve higher social welfare since it reduces significantly the probability of runs.
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