Reform of American Business Law

So finally in 1913 the US created their Federal Reserve System. But the distrust for any centralized power (including monetary power) persisted: the American system had a decentralized structure and decision-making power. The Great Crash of 1929 caught it without any capability to prevent the bank run of 1933. So this may be the right time to explain how a "bank run" works.

A run could be a random event u more or less dissociated from a downturn in the economic cycle, and more or less related to "mob psychology". In this case, they are "self-fulfilling prophecies". We all know that the Bank invests a part of our deposits, so if we all came at the same time to demand our deposits back, the Bank could never refund us all.

We all have our own insight bias, andf mine tells me that this prophecy is about to come true, so I "run" to the Bank, and so do you as soon as you see me running. We all run regardless of whether we actually need that money at that time or not. Worse, just because you are younger, you are likely to beat me to the first positions in the queue and get served as usual, on a first-come, first served basis.

When my turn comes, the Bank may not have sufficient liquid assets to meet my demand. It will have to liquidate some assets at a loss, meaning that those who wait get less than those who don't. So everybody runs as fast as his or her own legs permit.

By contrast, if Law was such that nobody believed that the State would let a Bank fail, only those with immediate needs for liquidity will withdraw their funds. Because the Bank is likely to have sufficient assets to meet this business-as-usual demand, there is no bank run.

This is a very simple version of the Diamond and Dybvig model developed in 1983. For those with more sophisticated economic background, there is another version including multiple equilibria and extraneous variables or "sunspots".

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