Avoiding bank runs in transition economies: The role of risk neutral capital

In a general equilibrium model with risk neutral and risk averse agents, we show that if banks issue both demand deposits and equity, then free banking is run-proof and efficient. In particular, we obtain the first best insurance solution if there is adequate risk neutral capital. If sufficient risk neutral capital is unavailable, then a partial suspension of convertibility is optimal. In general, therefore, policies like capital adequacy norms and deposit insurance are neither necessary nor desirable. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: G28; G21.