Efficient Financial Crises

We analyze the optimal capital structure and investment strategy of banks and other financial institutions. We develop conditions under which banks optimally choose a fragile capital structure that is subject to runs. We show that when bank depositors have limited ability to commit to long-term lending arrangements, they strictly prefer to lend to banks using short-term debt rather than with long-term debt or equity. We argue that when there are multiple banks, the same limited commitment of depositors leads them to prefer a financial system in which banks pursue correlated, risky investments as opposed to one in which banks pursue independent, less risky investments. The optimal financial system features occasional crises in which all banks are subject to ex-post inefficient liquidations, and in this sense, financial crises are efficient.