The Economics Book

318

D

uring the Great Depression

of the early 1930s some

9,000 US banks failed—a

third of the total. However, it was

not until the 1980s that economic

theory came to grips with basic

questions such as why banks exist,

and what causes a bank run—

where depositors panic and rush to

withdraw their money from banks

they think are at risk of failing. The

article that started the debate was

Bank Runs, Deposit Insurance, and

Liquidity, written in 1983 by US

economists Douglas Diamond and

Philip Dybvig. They showed that

even healthy banks can suffer from

a bank run and go bust.

Liquid investments

Diamond and Dybvig made a

mathematical model of an economy

to demonstrate how bank runs

occur. Their model has three points

in time—such as Monday, Tuesday,

and Wednesday—and assumes

that there is only one good or

product available to people, which

they can consume or invest.

Each person starts off with

a certain amount of the good.

On Monday people can do two

things with their good: they can

store it, in which case they get

back the same amount on Tuesday

to consume; or they can invest it.

If they choose to invest the good,

which is only possible on Monday,

they will receive much more of it

back on Wednesday. However,

if they cash in the investment

early on Tuesday, they will receive

BANK RUNS

IN CONTEXT

FOCUS

Banking and finance

KEY THINKERS

Douglas Diamond (1953– )

Philip Dybvig (1955 – )

BEFORE

1930–33 One third of all

US banks fail, leading to the

creation of the Federal Deposit

Insurance Corporation (FDIC)

to insure depositors’ money.

1978 US economic historian

Charles Kindleberger publishes

a landmark study of bank runs,

Manias, Panics, and Crashes:

A History of Financial Crises.

AFTER

1987–89 At the peak of the

decade-long US savings and

loan crisis, US bank failures

rise to a level of 200 per year.

2007–09 Thirteen countries

across the world experience

systemic banking crises.

Pessimism

can destroy

healthy banks.

A bank makes

long-term investments

but keeps some cash on

deposit for depositors who

wish to withdraw.

If customers become

fearful about

the future...

... and so will

default on its last

remaining depositors.

To honor their

withdrawals, the bank

must sell investments

at a loss...

... they will want to

withdraw ahead of

others, leading to a run

on the bank.

If any bank fails, a general

run upon the neighbouring

banks is apt to take

place, which if not

checked in the beginning

by a pouring into the

circulation of a very large

quantity of gold, leads to

extensive mischief.

Henry Thornton

UK economist (1760–1815)