Notes on "Bank Runs, Deposit Insurance, and Liquidity" (Douglas W. Diamond, Philip H. Dybvig)

Bank Runs, Deposit Insurance, and Liquidity

Douglas W. Diamond, Philip H. Dybvig

The Journal of political economy,Vol.9, No.3, (Jun.,1983), pp. 401-419

This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Inventions face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibrium, one of which is a bank run. Bank runs in the model cause real economic damage,rather than simply reflecting other problems. Contracts which can prevent runs are studied,and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

Eurodollar deposits tend to be uninsured and are therefore subject to bank runs, and this is true in the United States as well for deposits above the insured amount.

It is good that deregulation will leave banking more competitive, but we must ensure that banks will not be left vulnerable to runs.

Banks issuing demand deposits can improve on a competitive market by providing better risk sharing among people who need to consume at different random times.
The demand deposit contract providing this improvement has an undesirable equilibrium (a bank run) in which all depositors panic and withdraw immediately, including even those who would prefer to leave their deposits in if they were not concerned about the bank failing.
Bank runs cause real economic problems because even"healthy" banks can fail, causing the recall of loans and the termination of productive investment.

Banks are able to transform illiquid asset by offering liabilities with a different, smoother pattern of returns over time than the illiquid asset after 
-> confident-> risk sharing
-> panic -> bank run

Fisher (1911, p64)

A run occurs because the bank's assets, which are liquid but risky, no longer cover the nominally fixed liability (demand deposits), so depositors withdraw quickly cut their losses.

There is a feasible contract that allows banks both to prevent runs and to provide optimal risk sharing by converting illiquid assets

Model:

• An economy with a single bank (representing the financial intermediary industry)
• Deposit insurance dominates contracts which the bank alone can enforce shows that there is a potential benefit from government intervention into banking market
• There is a trade-off between optimal risk sharing and proper incentives for portfolio choice.
• The Fed discount window can, as a leader of last resort, provide a service similar to deposit insurance.
• If the technology is risky, the lender of last resort can no longer be as credible as deposit insurance.
• If the lenders of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks take on risk, even if bailouts  occurred only when many banks fail together.
• If the lender of last resort is not required to bail out banks unconditionally, a bank run can occur in response to changes in depositor expectations about the bank's credit worthiness.