Banking panics: The role of the first-come, first-served rule and information externalities

Abstract

This paper proposes that both the first-come, first-served rule and information externalities are important in causing contagious bank runs. The first-come, first-served rule creates a negative payoff externality among depositors. This payoff externality forces depositors to respond to early noisy information such as failures of other banks. Therefore, failures of a few banks may trigger runs on other banks. Contagious runs may occur even if (i) depositors choose the Pareto-dominant equilibrium when there are multiple equilibria and (ii) the deposit contract is chosen to maximize depositor welfare. The feasibility of reforming the FDIC to impose market discipline is also investigated.