Cause of the bank run:
1. Overview of NRB: NRB is a bank that built a successful business based on providing
mortgages to UK homeowners. Funding for mortgages liabilities gradually shifts from
traditional depositor funding to securitization and international wholesale money
market.
2. Cause of the bank run: a. the problem with NRB is the high risk business model
susceptible to the low probability, high impact events such as the sub prime crisis. When
the crisis hits, the bank cannot find short term funding source to roll over the short-term
funding of its assets and has to borrow from BoE.
b. Deposit protection: England has a understandard deposit protection scheme
(part of the Financial Services Compensation Scheme). only the first £ 2000 of a deposit
was fully protected and then only 90 percent of the value of deposits up to a limit of £
33,000
c. supervision system: responsibility for systematic stability and provision of
market liquidity remain with BoE, while the supervision of banks were transferred to
another entity. This create a conflict of interest
Diamond and Dybvig model
1. The banks in the model act as intermediaries between savers who prefer to deposit in
liquid accounts and borrowers who prefer to take out long-maturity loans and charge a
higher interest on loans than the interest on deposit and profit from that
Assumption:
Bank runs are costly
Bank performs the function of transforming illiquid asset to liquid liabilities (long term
loan into short term deposit)
We show that there is a feasible contract that allows banks
both to prevent runs and to provide optimal risk sharing by converting illiquid assets
->there is a contract which achieves the unconstrained optimum when
government deposit insurance is available.