Diamond–Dybvig model

The Diamond–Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets (such as business or mortgage loans) and liquid liabilities (deposits which may be withdrawn at any time) may give rise to self-fulfilling panics among depositors.

The model, published in 1983 by Douglas W. Diamond of the University of Chicago and Philip H. Dybvig, then of Yale University and now of Washington University in St. Louis, shows how an institution with long-maturity assets and short-maturity liabilities can be unstable.

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 maturity (that is, low liquidity). The same principle applies to individuals seeking financing to purchase large-ticket items such as housing or automobiles. On the other hand, individual savers (both households and firms) may have sudden, unpredictable needs for cash, due to unforeseen expenditures. So they demand liquid accounts which permit them immediate access to their deposits (that is, they value short maturity deposit accounts).

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.

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