Information Disclosure and Financial Fragility

Abstract

I study how banks and other financial intermediaries can use information disclosure to prevent self-fulfilling bank runs. I begin with a finite-agent version of Diamond and Dybvig (1983) with correlated liquidity shocks and sequential service. I allow the intermediary to inform each investor about the withdrawal decisions of previous investors. Adding information disclosure creates a withdrawal game with sequential signaling, and I argue using examples that it is natural to introduce an equilibrium concept placing restrictions on agents’ off equilibrium beliefs. I use the concept of forward induction equilibrium (Cho, 1987) that generalizes the “intuitive” criterion. I provide conditions under which the induced withdrawal game has a unique forward induction equilibrium and no bank run occurs. In other words, disclosing withdrawal information can promote financial stability.