and Liquidity Creation: A Simple Exposition of the Diamond-Dybvig Model

B anks make loans that cannot be sold quickly at a high price. Banks issuedemand deposits that allow depositors to withdraw at any time. Thismismatch of liquidity, in which a bank’s liabilities are more liquid than its assets, has caused problems for banks when too many depositors attempt to withdraw at once (a situation referred to as a bank run). Banks have followed policies to stop runs, and governments have instituted deposit insurance to prevent runs. Diamond and Dybvig (1983) develop a model to explain why banks choose to issue deposits that are more liquid than their assets and to understand why banks are subject to runs. The model has been widely used to understand bank runs and other types of financial crises, as well as ways to prevent such crises. This article uses narrative and numerical examples to provide a straightforward explanation of the ideas in Diamond and Dybvig (1983). Diamond and Dybvig (1983) argue that an important function of banks is to create liquidity, that is, to offer deposits that are more liquid than the assets that they hold. Investors who have a demand for liquidity will prefer to invest via a bank, rather than hold assets directly. Before discussing the I am grateful to Elizabeth Cammack for helpful comments on this article. The article gives an alternative exposition of Diamond-Dybvig (1983), and my understanding of these topics relies not only on my joint work with Phil Dybvig, but also on many subsequent conversations with him. This article is a revised and extended version of materials that I have presente