Explaining Bank Runs Using the Diamond-Dybvig Model

Economists Douglas Diamond and Philip Dybvig won the 2022 Nobel Prize in Economics for their Diamond-Dybvig Model. It explains how bank runs happen due to asset-liability mismatch and suggests deposit insurance to prevent them.

Basics

The history of banking has witnessed bank runs as a potential source of chaos and destruction for depositors and economies. Bank runs occur when numerous customers try to withdraw their money simultaneously due to concerns about the bank's solvency. While bank runs have caused the failure of many banks throughout history, it's only in recent decades that their causes and solutions have been explored in depth.

The Diamond-Dybvig Model

The Diamond-Dybvig Model is one of the most influential frameworks investigating the reasons behind bank runs and how to address them. In November 2022, the failure of FTX, a cryptocurrency exchange, raised questions about how runs on such platforms differ from those on traditional banks.

A Brief History of the Diamond-Dybvig Model

Douglas W. Diamond and Philip Dybvig, both economists and professors, are renowned for their 1983 paper titled "Bank Runs, Deposit Insurance, and Liquidity," which introduced the Diamond-Dybvig Model. This model earned them the 2022 Nobel Memorial Prize in Economics, along with former Federal Reserve Chairman Ben Bernanke. Diamond is affiliated with the University of Chicago, while Dybvig teaches at Washington University in St. Louis.

How Does the Diamond-Dybvig Model Work?

The role of banks as intermediaries between depositors and loan-takers is explored in the economic framework known as the Diamond-Dybvig Model. Depositors prefer liquid accounts for easy access to funds, while borrowers seek long-maturity, low-liquidity loans. The model suggests that banks create value through the liabilities they offer, providing depositors with an improved outcome and acting like insurance. Banks manage the risk of deposit withdrawals similar to how an insurance company operates. Additionally, banks serve borrowers by consolidating funds from many depositors, enabling large, long-term loans.

Fractional Reserve Banking and Bank Runs

The Diamond-Dybvig Model explains how banks' structure makes them vulnerable to runs. Bank runs happen when depositors panic about the bank's solvency and withdraw their funds. Since banks have long-term loans, they can't immediately call them in. This forces them to sell investments at a loss to pay depositors. Early withdrawers succeed, but others may not. A run becomes a self-fulfilling prophecy as depositors rush to get their money back. If many depositors withdraw at once, it increases the risk of a bank failure.

Preventing Bank Runs: Deposit Insurance

In the past, banks attempted to halt bank runs by temporarily blocking customer withdrawals, but this method failed to address the underlying panic that triggered the runs and left some depositors unable to access their funds.

A more effective approach proposed by Diamond and Dybvig is deposit insurance. Their model identifies the mismatch between loans and deposits as a key cause of bank runs. By providing deposit insurance through a central bank or government agency like the FDIC, the risk of runs can be reduced. Deposit insurance ensures that depositors receive some or all of their money back during a run, boosting public confidence and leading to a decline in bank runs since the Great Depression. However, a potential downside of deposit insurance is that increased trust in the banking system may incentivize banks to take on excessive risks, assuming that runs are unlikely.

Crypto Exchanges Bank Runs

The difference between cryptocurrency exchanges and traditional banks is highlighted by high-profile runs, such as the collapse of FTX in 2022. Unlike insured banks, cryptocurrency exchanges lack deposit insurance from the FDIC or any government body, leaving individuals storing their digital tokens without the same safety guarantees. This absence of a safety net increases the vulnerability of crypto exchanges to panic-driven runs.

Conclusion

The mismatch between bank assets and liabilities can cause liquidity problems that the Diamond-Dybvig model sheds light on in terms of bank runs. By providing deposit insurance, depositor concerns can be alleviated, leading to a decreased likelihood of a bank failure due to a concentrated run on funds.