The Diamond and Dybvig mannequin was first described in a seminal paper by Douglas W. Diamond and Philip H. Dybvig in 1983 in a well-known article from the Journal of Political Economic system, “Financial institution Runs, Deposit Insurance coverage and Liquidity”. You may consider this mannequin as our most basic understanding, in modeled type, of how monetary intermediation works. It is a foundation for a way economists take into consideration deposit insurance coverage and likewise in regards to the Fed’s lender-of-last-resort capabilities.
here’s a exhibition 2007 of the Diamond mannequin. You can begin with the essential concept that financial institution property are sometimes illiquid, however depositors need to be liquid. If you’re a depositor and maintain 1/2000 of a mortgage on the native Chinese language restaurant, you can not very simply write a test or make a bank card transaction based mostly on that mortgage. The mortgage could be costly to promote and the bid-ask unfold could be excessive.
Now enter the banks. Banks maintain and grant the loans and bear the danger of fluctuation within the worth of those property. On the similar time, banks situation liquid demand deposits to their clients. Prospects have money and banks maintain property. Clearly, for this to work, banks will (on common) earn extra on their loans than they pay on deposits. Nonetheless, clients desire this association as they’ve transferred the dangers and liquidity points to the financial institution.
This association works as a result of (often) not all clients need to withdraw their cash from the financial institution on the similar time. In fact, we name it a financial institution run.
Within the occasion of a financial institution run, the financial institution can solely repay clients by promoting a big proportion of the loans, if not all of them. However we now have already famous that these loans are illiquid and can’t be simply offered at worth, particularly if the banks attempt to promote them abruptly.
Be aware that on this mannequin there are a number of equilibria. In an equilibrium, clients count on different clients to belief the financial institution and there’s no large rush to withdraw all deposits. In one other steadiness, everybody expects a financial institution run and it turns into a self-fulfilling prophecy. In spite of everything, if you realize that the financial institution could have bother assembly its commitments, you’ll attempt to withdraw your cash as quickly as attainable.
Within the easiest type of this mannequin, the financial institution is a mutual, owned by clients. There may be subsequently no resolution by an impartial shareholder to take a position capital to restrict the danger of a foul end result. Some economists have thought of the Diamond-Dybvig mannequin to be restricted for that reason, however over time the mannequin has been enriched with a greater variety of assumptions, together with by Diamond himself (with Rajan). It gave rise to a all of the literature on the microeconomics of economic intermediation, spawning hundreds of papers in an identical theoretical vein.
The mannequin additionally embodies what is named a “sequential service constraint”. In different phrases, the preliminary financial institution is compelled to comply with a “first come, first served” strategy to serving clients. If we calm down the sequential service constraint, it’s attainable to cease financial institution runs by a richer set of contracts. For instance, the financial institution might reserve the suitable to restrict or droop or delay convertibility, probably with a bonus then despatched to clients for expectation. These incentives, or different comparable contracts, may have the ability to cease the financial institution run.
On this mannequin, the financial institution run doesn’t happen as a result of the financial institution is bancrupt. As a substitute, the financial institution rush happens due to “sunspots” – a rush happens as a result of a rush is anticipated. If the financial institution is bancrupt, merely suspending convertibility won’t clear up the elemental downside.
It is fairly straightforward to see how deposit insurance coverage or a Fed lender of final resort can enhance the underside line. If clients begin an incipient run on the financial institution, the FDIC or Fed merely ensures the deposits. There may be then no motive for the race to proceed and the economic system to proceed to evolve in a Pareto-superior manner. In fact, deposit insurance coverage or the Fed can create ethical hazard issues for banks – they is likely to be taking an excessive amount of danger given these ensures – and these issues have been explored in additional element in later literature.
Alongside associated (however fairly completely different!) traces, Diamond (solo) has an article from the 1984 Assessment of Financial Research “Monetary Intermediation and Delegated Supervision”. This text fashions the advantages of economic intermediation in fairly a special manner. There’s a want to watch mortgage high quality, and banks have a comparative benefit in doing so over depositors. As well as, the financial institution can monitor the standard of loans in a diversified manner, because it holds many loans in its portfolio. Financial institution supervision includes much less danger than depositor supervision, along with being more cost effective. This piece additionally had a significant affect on later literature.
Right here is Diamond on google.scholar.com – you possibly can see that he’s a really targeted economist. Right here is Dybvig on Scholar.google.commost of his different papers within the space of finance extra narrowly, however he received the prize for this work on banking and intermediation. his piece on asset valuation and the time period construction of rates of interest is well-known.
Right here is all the things Swedish information on the researchers and their work. I have never learn them but, however they’re usually very nicely carried out.
All in all, these pricing decisions weren’t in any respect shocking, they usually’ve been anticipated for a number of years.