Anticipated Banking Panics (with Mark Gertler and Nobu Kiyotaki)

Abstract:
We develop a macroeconomic model with banking instability. Sunspot runs can arise that are harmful to the economy. However, whether a run equilibrium exists depends on fundamentals. In contrast to earlier work, the probability of a sunspot run is the outcome of rational forecast based on fundamentals. The model captures the movement from slow to fast runs that was a feature of the Great Recession: A weakening of banks’ balance sheets increases the probability of a run, leading depositors to withdraw funds from banks. These slow runs have harmful effects on the economy and set the stage for fast runs. We then turn to study optimal leverage restrictions in this setup. The optimal policy corrects both traditional pecuniary externalities and a new type of externality arising from agents’ failure to factor in the effect of their leverage choices on the probability of a systemic run. We study the interaction and relative quantitative importance of pecuniary externalities and this “run externality”.