Demand–Deposit Contracts and the Probability of Bank Runs

ABSTRACT Diamond and Dybvig (1983) show that while demand–deposit contracts let banks provide liquidity, they expose them to panic‐based bank runs. However, their model does not provide tools to derive the probability of the bank‐run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic‐based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand–deposit contract that trades off the benefits from liquidity against the costs of runs.