Diamond-Dybvig Model: Theory of Bank Runs

All through the lengthy historical past of banking, the phenomenon of the financial institution run has loomed as a possible supply of chaos and destruction, each for particular person depositors and economies. Financial institution runs happen when numerous prospects with deposits at a financial institution try to withdraw their cash on the similar time, often over considerations concerning the solvency of the financial institution.

Over the centuries—and as lately because the 2008 monetary disaster—financial institution runs have led to the failure of many banks. But it surely has solely been in the previous couple of many years that the causes of and potential options to financial institution runs have been explored in better depth.

One of the vital influential fashions exploring why financial institution runs occur and the way they are often addressed is the Diamond-Dybvig Mannequin. Discover out extra about this vital framework, and the way current high-profile runs on cryptocurrency exchanges—together with the failure of FTX in November 2022—differ from runs on conventional banks.

Key Takeaways

  • Douglas Diamond and Philip Dybvig are economists and winners of the 2022 Nobel Memorial Prize in Economics.
  • They’re identified for the Diamond-Dybvig Mannequin of financial institution runs, which explores the phenomenon of depositor runs on banks.
  • The mannequin suggests {that a} mismatch between belongings and liabilities and liquidity considerations might go away banks susceptible to runs.
  • Financial institution runs could also be attributable to depositor panic, however as a run turns into extra probably, the rational strategy for every particular person depositor is to attempt to withdraw their funds.
  • The mannequin theorizes that deposit insurance coverage can quell panic and scale back the probability of financial institution runs.
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Who Are Douglas Diamond and Philip Dybvig?

Douglas W. Diamond and Philip Dybvig are economists and professors on the College of Chicago and Washington College in St. Louis, respectively. They every have labored in a wide range of areas of analysis, however they’re maybe finest identified for a 1983 paper known as “Financial institution Runs, Deposit Insurance coverage, and Liquidity.” It introduced their work that has since come to be generally known as the Diamond-Dybvig Mannequin. Diamond, Dybvig, and former Federal Reserve Chairman Ben Bernanke have been recipients of the 2022 Nobel Memorial Prize in Economics.

What Is the Diamond-Dybvig Mannequin?

The Diamond-Dybvig Mannequin is an financial mannequin that explores the position of banks as intermediaries that create liquid claims towards illiquid belongings. Banks present companies to each depositors, who are inclined to want liquid accounts in case they want quick access to funds, and loan-takers, together with companies and people making massive purchases, who usually search for long-maturity, low-liquidity loans.

The mannequin means that banks create worth by the liabilities they provide to prospects. For particular person depositors, banks present an improved consequence relative to different funding choices by, in impact, offering insurance coverage. Financial institution depositors have the proper to withdraw their deposits at any time, and the financial institution manages this threat in a lot the identical method that an insurance coverage firm would. Banks additionally present a priceless service to debtors by consolidating funds from many depositors to make attainable massive, long-term loans.

The Difficulty of Financial institution Runs

The Diamond-Dybvig Mannequin posits that the way in which that banks function essentially—by providing short-dated claims towards long-dated belongings—leaves them susceptible to runs. Financial institution runs could also be triggered just by panic. As depositors fear concerning the solvency of the financial institution, they transfer to withdraw their funds.

As a result of a financial institution’s loans sometimes have lengthy maturities, it may’t instantly name within the loans. The financial institution will then be compelled to liquidate its investments, usually at a loss, in an effort to pay depositors. Because the financial institution runs out of cash, the primary depositors to withdraw funds can be profitable, however later depositors is probably not.

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Diamond and Dybvig’s concept means that financial institution runs could also be self-fulfilling prophecies. Within the occasion of a run, it turns into rational for a depositor to attempt to get their a refund as rapidly as attainable due to the true risk that being too late might imply dropping the cash for good.

In response to Diamond and Dybvig’s mannequin, if sufficient depositors all attempt to get their funds again directly, it is in one of the best curiosity of all depositors to do the identical, though the extra depositors attempting to get a refund, the extra probably a financial institution failure turns into.

How To Cease a Financial institution Run

Traditionally, banks usually have tried to cease financial institution runs by the “suspension of convertibility,” primarily blocking prospects from making withdrawals to forestall insolvency. Nonetheless, this methodology, whereas probably efficient at blocking the run, does not handle the underlying panic which will have prompted the run within the first place, and it nonetheless ends in some depositors not having the ability to entry funds.

Diamond and Dybvig argue that deposit insurance coverage is a preferable various strategy to managing financial institution runs, quite than utilizing the suspension of convertibility. As mentioned, their mannequin factors to the mismatch of mortgage belongings and deposit liabilities as a consequence of liquidity considerations as a key reason for financial institution runs. They posit that deposit insurance coverage issued by a central financial institution or federal authorities company (such because the Federal Deposit Insurance coverage Corp., or FDIC) may also help to resolve this challenge.

Deposit insurance coverage is designed to pay depositors some or all of their a refund within the case of a financial institution run or failure. With the assured safety of their funds from the federal government, depositors are much less more likely to panic over considerations a few financial institution’s solvency, making a run much less probably as effectively. Deposit insurance coverage has efficiently diminished the variety of financial institution runs and failures by bolstering public confidence for the reason that FDIC was based following the Nice Melancholy.

There are potential downsides to deposit insurance coverage, nevertheless. If depositors are extra trusting of the banking system, banks could also be incentivized to tackle extreme threat, realizing {that a} run is unlikely.

Runs on Cryptocurrency Exchanges

Current high-profile runs on cryptocurrency exchanges, together with the collapse of FTX in late 2022, spotlight an vital distinction between these exchanges and conventional banks. The FDIC does not present deposit insurance coverage to crypto exchanges, nor does the FDIC insurance coverage cowl cryptocurrency.

Due to the dearth of insurance coverage from a governmental physique or central financial institution, people storing their digital tokens with a cryptocurrency alternate lack the identical ensures that depositors at an insured financial institution have. Thus, there isn’t any comparable security internet to scale back panic and forestall a run, leaving crypto exchanges extremely susceptible to this phenomenon.

Who Are Diamond and Dybvig?

Douglas W. Diamond and Philip Dybvig are economists and professors identified for an influential 1983 paper that presents an financial mannequin of financial institution runs and suggests methods to keep away from them.

What Does the Diamond-Dybvig Mannequin Say About Financial institution Runs?

The Diamond-Dybvig mannequin means that by taking short-term deposits and issuing long-term loans, banks might go away themselves susceptible to financial institution runs. Nonetheless, deposit insurance coverage offered by the FDIC or an identical federal company will be efficient at stopping financial institution runs.

How Does Deposit Insurance coverage Work?

The FDIC supplies deposit insurance coverage to cowl some or all of the funds depositors maintain at insured banks. This insurance coverage supplies a assure that, within the occasion of a run, depositors will not lose all their cash. This assurance can scale back the probability of financial institution runs by sustaining depositor religion within the banking system.

The Backside Line

The Diamond-Dybvig mannequin supplies a framework for understanding financial institution runs as arising out of liquidity points as a consequence of a mismatch between financial institution belongings and liabilities. Deposit insurance coverage might assist to calm depositor considerations, decreasing the probabilities of a concentrated run on depositor funds and, in flip, the probability of a financial institution failure.