Costly financial crises

This paper presents a model consistent with the business cycle view of the origins of banking panics. As in Allen and Gale [1], bank runs arise endogenously as a consequence of the standard deposit contract in a world with aggregate uncertainty about asset returns. The purpose of the paper is to show that Allen and Gale's result about the optimality of bank runs depends on individuals's preferences. In a more general framework, considered in the present work, a laisse-faire policy can never be optimal, and therefore, regulation is always needed in order to achieve the first best. This result supports the traditional view that bank runs are costly and should be prevented with regulation