Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Introduction to the Special Issue on the Diamond-Dybvig Model

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Introduction to the Special Issue on the Diamond-Dybvig Model

Article excerpt

This special issue of the Economic Quarterly is dedicated to the 1983 model of bank runs developed by Douglas Diamond and Philip Dybvig.1 Their model has been a workhorse of banking research over the last 25 years and during the recent financial crisis it has been one that researchers and policymakers consistently turn to when interpreting financial market phenomena.

The Diamond-Dybvig model has three basic elements:

* Long-term investments that are more productive than short-term investments;

* A random need for liquidity on the part of an individual; and

* Private information about an individual's need for liquidity.

With these elements, Diamond and Dybvig (DD hereafter) show that it is desirable for people to pool their funds and jointly invest in productive long-term investments, while allowing individuals to withdraw their funds on demand, even before the end of the life of the long-term investments. Furthermore, they show that it is also desirable to set payouts for early withdrawals high enough so that if every person in the pool withdrew his funds early, there would not be enough funds available to meet every withdrawal.

DD interpreted this arrangement as a bank because it contains two important characteristics that are typically identified with banks. First, it performs maturity transformation, that is, it backs short-term liabilities with long-term illiquid assets. Second, it issues liabilities that are payable on demand, that is, bank deposits.2

According to DD, while this arrangement is effective at increasing output and providing liquidity insurance, it is also susceptible to a bank run. In their environment, there is a coordination problem among depositors. If too many people withdraw early, then the long-term investments are liquidated early causing a loss in output. DD show that there is such an equilibrium in that depositors who do not need early liquidity will still withdraw early because they think that other depositors without an early liquidity need are going to withdraw early. This inefficient allocation is an equilibrium (as is the efficient allocation) even if the bank is solvent.

Diamond and Dybvig also discuss several mechanisms for eliminating the run equilibrium. These include deposit insurance, suspension mechanisms, and central bank lending. All of these mechanisms have been used to various degrees over time. The United States has had federal government-provided deposit insurance since 1933. The precursors to central banks, the clearinghouses, often would suspend payments during a financial crisis (Timberlake 1984). Finally, the lender-of-last-resort justification of central bank lending has been used heavily in this crisis and it was heavily used historically. For example, Bagehot (1873), when writing about the Bank of England, gave his famous dictum that to prevent a financial panic, a central bank should freely lend at a penalty rate on good collateral.

1. DIAMOND-DYBVIGAND THE RECENT FINANCIAL CRISIS

Until recently, bank runs were not considered a major problem in the United States. The introduction of deposit insurance in the 1930s was considered to have essentially solved this problem. There had been very few bank runs since then.3 Much of the academic literature instead focused on the sizeable costs of moral hazard that can come with a deposit insurance system, as was seen in the savings and loan crisis of the 1980s (see, for example, White [1991]).

What the academic and policy worlds missed was just how much some of the newer (since the 1970s) financial arrangements were starting to resemble banks in that they performed maturity transformation and financed assets with liabilities that resembled demand deposits. Many of these arrangements ran into trouble during the financial crisis when they could not roll over their short-term debt. Whether these episodes match the DD equilibrium in which a solvent bank is run because of a panic is still a topic of debate. …

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