The Diamond–Dybvig model of bank runs as a coordination game

Abstract

A bank run occurs when a large number of customers withdraw their deposits from a financial institution at the same time. This can destabilise the bank to the point where it runs out of cash and thus faces sudden bankruptcy. As more people withdraw their deposits, the likelihood of bankruptcy increases, thus triggering further withdrawals. In game theory this type of situation can be modelled as a “coordination game”, that is, a game with two pure equilibria: If sufficiently many people keep their money in the bank, then it will not default and it is rational for everyone to keep their money in the bank. On the other hand, if sufficiently many people withdraw their deposits the bank will default and it is then rational for everyone to try to withdraw their deposits. The overall objective of this study is to explain the phenomenon of bank runs by introducing the Diamond–Dybvig model. This model assumes that the function of a bank is to offer both long-term loans for investments and relatively short-term deposit service. Bank runs comes out as one of two equilibria when too many withdraw early before the long-term loans is paid back. Our task is to find out the condition that can lead to bank runs and more importantly, we will suggest two ways to address the problem of bank runs

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Last time updated on 03/09/2020

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