Diamond-Dybvig Model: Theory of Bank Runs

Throughout the long history of banking, the phenomenon of the bank run has loomed as a potential source of chaos and destruction, both for individual depositors and economies. Bank runs occur when a large number of customers with deposits at a bank attempt to withdraw their money at the same time, usually over concerns about the solvency of the bank.

Over the centuries—and as recently as the 2008 financial crisis—bank runs have led to the failure of many banks. But it has only been in the last few decades that the causes of and potential solutions to bank runs have been explored in greater depth.

One of the most influential models exploring why bank runs happen and how they can be addressed is the Diamond-Dybvig Model. Find out more about this important framework, and how recent high-profile runs on cryptocurrency exchanges—including the failure of FTX in November 2022—differ from runs on traditional banks.

Who Are Douglas Diamond and Philip Dybvig?

Douglas W. Diamond and Philip Dybvig are economists and professors at the University of Chicago and Washington University in St. Louis, respectively. They each have worked in a variety of areas of research, but they are perhaps best known for a 1983 paper called "Bank Runs, Deposit Insurance, and Liquidity." It presented their work that has since come to be known as the Diamond-Dybvig Model. Diamond, Dybvig, and former Federal Reserve Chairman Ben Bernanke were recipients of the 2022 Nobel Memorial Prize in Economics.

What Is the Diamond-Dybvig Model?

The Diamond-Dybvig Model is an economic model that explores the role of banks as intermediaries that create liquid claims against illiquid assets. Banks provide services to both depositors, who tend to prefer liquid accounts in case they need easy access to funds, and loan-takers, including businesses and individuals making large purchases, who often look for long-maturity, low-liquidity loans.

The model suggests that banks create value by the liabilities they offer to customers. For individual depositors, banks provide an improved outcome relative to other investment options by, in effect, providing insurance. Bank depositors have the right to withdraw their deposits at any time, and the bank manages this risk in much the same way that an insurance company would. Banks also provide a valuable service to borrowers by consolidating funds from many depositors to make possible large, long-term loans.

The Issue of Bank Runs

The Diamond-Dybvig Model posits that the way that banks operate fundamentally—by offering short-dated claims against long-dated assets—leaves them vulnerable to runs. Bank runs may be caused simply by panic. As depositors worry about the solvency of the bank, they move to withdraw their funds.

Because a bank's loans typically have long maturities, it can't immediately call in the loans. The bank will then be forced to liquidate its investments, often at a loss, in an effort to pay depositors. As the bank runs out of money, the first depositors to withdraw funds will be successful, but later depositors may not be.

Diamond and Dybvig's theory suggests that bank runs may be self-fulfilling prophecies. In the event of a run, it becomes rational for a depositor to try to get their money back as quickly as possible because of the real possibility that being too late may mean losing the money for good.

How To Stop a Bank Run

Historically, banks often have attempted to stop bank runs by the "suspension of convertibility," essentially blocking customers from making withdrawals to prevent insolvency. However, this method, while potentially effective at blocking the run, doesn't address the underlying panic that may have prompted the run in the first place, and it still results in some depositors not being able to access funds.

Diamond and Dybvig argue that deposit insurance is a preferable alternative approach to managing bank runs, rather than using the suspension of convertibility. As discussed, their model points to the mismatch of loan assets and deposit liabilities due to liquidity concerns as a key cause of bank runs. They posit that deposit insurance issued by a central bank or federal government agency (such as the Federal Deposit Insurance Corp., or FDIC) can help to solve this issue.

Deposit insurance is designed to pay depositors some or all of their money back in the case of a bank run or failure. With the guaranteed protection of their funds from the government, depositors are less likely to panic over concerns about a bank's solvency, making a run less likely as well. Deposit insurance has successfully reduced the number of bank runs and failures by bolstering public confidence since the FDIC was founded following the Great Depression.

There are potential downsides to deposit insurance, however. If depositors are more trusting of the banking system, banks may be incentivized to take on excessive risk, knowing that a run is unlikely.

Runs on Cryptocurrency Exchanges

Recent high-profile runs on cryptocurrency exchanges, including the collapse of FTX in late 2022, highlight an important distinction between these exchanges and traditional banks. The FDIC doesn't provide deposit insurance to crypto exchanges, nor does the FDIC insurance cover cryptocurrency.

Because of the lack of insurance from a governmental body or central bank, individuals storing their digital tokens with a cryptocurrency exchange lack the same guarantees that depositors at an insured bank have. Thus, there is no comparable safety net to reduce panic and prevent a run, leaving crypto exchanges highly vulnerable to this phenomenon.

The Bottom Line

The Diamond-Dybvig model provides a framework for understanding bank runs as arising out of liquidity issues due to a mismatch between bank assets and liabilities. Deposit insurance may help to calm depositor concerns, reducing the chances of a concentrated run on depositor funds and, in turn, the likelihood of a bank failure.