On sunspots, bank runs, and Glass–Steagall

Abstract

We analyze the pre‐deposit game in a two‐depositor banking model. The Glass–Steagall bank is assumed to be restricted to holding only liquid assets. Depositors tolerate a panic‐based run if its probability of occurrence s is small. How s affects the allocation of assets depends on the incentive compatibility constraint (ICC). When the ICC is not binding, the sunspot allocation is not a mere randomization over the run and non‐run outcomes under the so‐called “optimal contract.” We offer this paper as a contribution to both the literature on banking and financial fragility and also the broader literature on sunspot equilibrium.