Economics & Finance / Finance & Investment / Banking & Credit

"Bank Runs, Deposit Insurance, and Liquidity," authored by Douglas Diamond and Philip Dybvig,

Bank Runs, Deposit Insurance, and Liquidity

Douglas Diamond, Philip Dybvig

Nobel Prize in Economics Papers Series： This article, "Bank Runs, Deposit Insurance, and Liquidity," authored by Douglas Diamond and Philip Dybvig, explains how banks provide necessary risk-sharing services by converting illiquid assets into highly liquid liabilities. The authors point out that while demand deposit contracts meet investors' liquidity needs, this mechanism exists in multiple equilibria, one of which is the highly destructive bank run. When depositors panic and withdraw funds in anticipation of bank failure, even healthy banks can fall into a real crisis due to being forced to liquidate assets at a discount. To address this vulnerability, the article explores protective mechanisms such as suspension of deposit exchanges and government deposit insurance. The study ultimately shows that government-backed deposit insurance is more effective in preventing bank runs and achieving optimal resource allocation because it breaks the chain reaction triggered by panic without sacrificing liquidity.