Illiquidity Runs

We develop a debt run model in which a bank dynamically rebalances its portfolio and runs have a permanent impact. Higher illiquidity of the bank’s assets adversely affects its solvency ratio, and therefore creditors run earlier. As its solvency ratio deteriorates, the bank initially scales back its investment in risky illiquid assets to avoid closure. When its solvency ratio falls even lower, the bank gambles for resurrection. Liquidity regulation restricts the bank’s risk-shifting ability and therefore decreases its probability of closure by the regulator. Finally, we show that uncertainty about the regulator’s intervention policy increases the probability of a bank run occurring.