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Federal Reserve Bank of Minneapolis Quarterly Review, Winter 2000 | Go to article overview

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One of the most disturbing features of monetary history is systemwide bank runs. In the United States, for example, before the creation of federal deposit insurance in 1933, the nation's banking system endured numerous bank panics, periods when depositors rushed to withdraw their funds because they thought their banks might fail. After the Civil War, the nation had major bank panics in almost every decade. Between 1929 and 1933 alone, the United States had three such panics, during which more than 8,800 commercial banks suspended operations.

What causes this instability in the banking industry? Do systemwide bank runs merely reflect problems in the broader U.S. economy? Or do these bank runs instead indicate that banking itself is inherently unstable? And if banking is inherently unstable, what is the best way for policymakers to respond to this instability? Unfortunately, economists don't yet have definitive answers to these questions. We do have tentative answers, though, and to try to strengthen them, this issue of the Quarterly Review reexamines what many economists consider the most coherent model of bank runs, the 1983 model of Douglas W. Diamond and Philip H. Dybvig.

The Diamond and Dybvig model has clear answers to our questions: banking is indeed inherently unstable, and the appropriate policy response is deposit insurance. In a version of this model with aggregate uncertainty, agents optimize and markets clear, and yet an equilibrium with bank runs can occur. In the model, the bank run equilibrium can be prevented with deposit insurance, although not without the risk of moral hazard. (Just how costly moral hazard can be was demonstrated in the United States shortly after Diamond and Dybvig's article was published: about 1,000 banks failed, draining the deposit insurance fund, and about 1,000 savings and loan associations failed too, costing taxpayers roughly $150 billion.) While some economists have found reasons to question certain aspects of Diamond and Dybvig's model, as well as its policy implications, no one has yet found a more convincing way to model bank runs. …

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