Diamond–Dybvig model
This article includes a list of general references, but it lacks sufficient corresponding inline citations. (January 2010) |
The Diamond–Dybvig model is an influential
Theory
The model, published in 1983 by
Structure of the model
Diamond and Dybvig's paper points out that business investment often requires expenditures in the present to obtain returns in the future. Therefore, they prefer loans with a long
The banks in the model act as intermediaries between savers who prefer to deposit in liquid accounts and borrowers who prefer to take out long-maturity loans. Under ordinary circumstances, banks can provide a valuable service by channeling funds from many individual deposits into loans for borrowers. Individual depositors might not be able to make these loans themselves, since they know they may suddenly need immediate access to their funds, whereas the businesses' investments will only pay off in the future (moreover, by aggregating funds from many different depositors, banks help depositors save on the transaction costs they would have to pay in order to lend directly to businesses). Since banks provide a valuable service to both sides (providing the long-maturity loans businesses want and the liquid accounts depositors want), they can charge a higher interest rate on loans than they pay on deposits and thus profit from the difference.
Nash equilibria of the model
Diamond and Dybvig point out that under ordinary circumstances, savers' unpredictable needs for cash are likely to be random, as depositors' needs reflect their individual circumstances. Since depositors' demand for cash are unlikely to occur at the same time, by accepting deposits from many different sources the bank expects only a small fraction of withdrawals in the short term, even though all depositors have the right to withdraw their full deposit at any time. Thus, a bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors that wish to make withdrawals.
However a different outcome is also possible. Since banks lend out at long maturity, they cannot quickly call in their loans. And even if they tried to call in their loans, borrowers would be unable to pay back quickly, since their loans were, by assumption, used to finance long-term investments. Therefore, if all depositors attempt to withdraw their funds simultaneously, a bank will run out of money long before it is able to pay all the depositors. The bank will be able to pay the first depositors who demand their money back, but if all others attempt to withdraw too, the bank will go bankrupt and the last depositors will be left with nothing.
This means that even healthy banks are potentially vulnerable to panics, usually called bank runs. If a depositor expects all other depositors to withdraw their funds, then it is irrelevant whether the banks' long term loans are likely to be profitable; the only rational response for the depositor is to rush to take his or her deposits out before the other depositors remove theirs. In other words, the Diamond–Dybvig model views bank runs as a type of self-fulfilling prophecy: each depositor's incentive to withdraw funds depends on what they expect other depositors to do. If enough depositors expect other depositors to withdraw their funds, then they all have an incentive to rush to be the first in line to withdraw their funds.
Policy implications
In practice, due to
Thus, sufficient deposit insurance can eliminate the possibility of bank runs. In principle, maintaining a deposit insurance program is unlikely to be very costly for the government: as long as bank runs are prevented, deposit insurance will never actually need to be paid out. However an IMF working paper has questioned the effectiveness of deposit insurance in a crisis.[4]
Case from US economic history
Bank runs became much rarer in the U.S. after the Federal Deposit Insurance Corporation was founded in the aftermath of the bank panics of the Great Depression. On the other hand, a deposit insurance scheme is likely to lead to moral hazard: by protecting depositors against bank failure, it makes depositors less careful in choosing where to deposit their money, and thus gives banks less incentive to lend carefully.
See also
- Asset–liability mismatch
- Coordination game
- Liquidity preference
- Money demand
- Sunspot equilibrium
References
- ^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022". NobelPrize.org. Retrieved 2023-04-27.
- ^ Announcement of the 2022 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, retrieved 2023-04-27
- OCLC 1360456914.)
{{cite book}}
: CS1 maint: location missing publisher (link - ^ Garcia, G. G.; Department, IMF Monetary and Exchange Affairs; IMF (2000). "Deposit insurance and crisis management /: prepared by Gillian Garcia".
{{cite journal}}
: Cite journal requires|journal=
(help)
Further reading
- Diamond DW, Dybvig PH (1983). "Bank runs, deposit insurance, and liquidity". S2CID 14214187. Reprinted (2000) Fed Res Bank Mn Q Rev24 (1), 14–23.
- Diamond DW (2007). "Banks and liquidity creation: a simple exposition of the Diamond-Dybvig model" (PDF). Fed Res Bank Richmond Econ Q. 93 (2): 189–200. Archived from the original (PDF) on 2012-05-13. Retrieved 2008-10-17.
- Johnson, Simon; Ahlander, Johan (2022-10-10). "Banking crisis breakthroughs win Nobel economics prize for Bernanke, Diamond, Dybvig". Reuters. Retrieved 2022-10-11.