ABSTRACT
A BENCHMARK MODEV If one is to understand and cure disease, it helps first to have a clear idea of health. Imagine that we have a banking system with no government intervention, and therefore no government deposit insurance. Those who hold bank deposits want reassurance that their savings are safe - that the bank will be able to pay back their deposits as promised - and those who borrow from banks want reassurance that their bank will not get into financial difficulties which might interrupt the credit they receive. Market forces will then lead banks to reassure their customers in various ways. Banks can give depositors the right to withdraw their funds on demand, without notice. A banker who agrees to such a contract gives depositors the right to discipline him at any moment they chose by withdrawing their funds (see, for example, Kaufman 1988c; Calomiris and Kahn 1991). Such a banker will, of course, be acutely vulnerable to the potential loss of depositor confidence, and the fact that he can do little that might disturb that confidence is what reassures his customers and gives them confidence in the first place. A banker exposed to this discipline must constantly look over his shoulder to take account of how his depositors would react. Paradoxically, therefore, though a run might weaken and possibly destroy a bank should it occur ex post, the vulnerability to a run - the threat of a run - helps to stabilize the banking system by imposing a discipline that limits a bank's scope to 'misbehave' .
