WTH thought I could go back to tracking the demises of various banks like in the aftermath of 2008. So far there’s not very many.
I did do a little research, tho’. I found Krugman’s take on last year’s Nobel in Economics. He usually does a good job of explaining things.
Unfortunately, as Diamond and Dybvig pointed out, a system in which financial intermediaries borrow liquid but invest illiquid tends to have multiple equilibria. If everyone expects the system to work, it does. But if people come to expect other people to withdraw funds en masse, they will rush to withdraw their own funds too, breaking banks that can’t easily liquidate their investments.
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So Diamond-Dybvig showed, in a minimalist model, that banking is a productive activity but also one that creates systemic risk unless backed by a public safety net. And from that insight, a lot of other things follow.
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There’s other interesting articles if you scroll down.
They proved it works for shadow banks, as well as regular banks and made the case for regulations for anything that resembles a financial institution.
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Diamond and Dybvig showed, however, that destructive bank runs can happen even in a fundamentally sound financial system — they don’t have to be the result of past folly and too much leverage. And the policy response should focus more on containing the risks of panic than on preventing financial excesses.
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