- Person
- Douglas Diamond
- Lived
- b. 1953
- Field
- Finance, banking
- From
- American
The story
Douglas Diamond was born in Chicago in 1953; his father’s parents were Jewish, his grandfather having emigrated from Austria as a teenager to New York, and his mother’s family was Catholic. As a student he was struck by Milton Friedman and Anna Schwartz’s account of the waves of bank failures in the Great Depression, and he went on to spend his career at the University of Chicago studying what banks do and why they fail.
With Philip Dybvig, whom he met as a fellow student of Stephen Ross at Yale, he set out to model bank runs using game theory. Their paper “Bank Runs, Deposit Insurance, and Liquidity,” published in the Journal of Political Economy in 1983, starts with a simple observation. Savers want to be able to withdraw their money at any time, while the businesses and homebuyers who borrow need long-term loans. Banks bridge the gap by taking deposits that can be withdrawn on demand and lending them for years. This is how banks create liquidity, and it is valuable to everyone.
But it also makes banks fragile. Since a bank never holds enough cash to pay all its depositors at once, if depositors fear that others will withdraw, each has a reason to get there first. The fear becomes self-fulfilling, and a perfectly sound bank can be forced to sell its loans at a loss and fail. Diamond and Dybvig showed that a government guarantee of deposits removes the reason to run. When savers know their money is safe, they stay calm and the run never begins, so in theory the insurance never needs to be paid out. The Royal Swedish Academy of Sciences noted that this explains why most countries now have deposit insurance schemes.
The academy described Diamond and Dybvig’s insights as the foundation of modern bank regulation, from deposit insurance to central bank lending of last resort and rules on banks’ liquid assets. When runs hit shadow banks, institutions that borrowed short and lent long outside the regulated system, in the 2008–2009 financial crisis, the same model explained what was happening. Diamond himself worked on proposals for financial reform during that crisis and advised the U.S. Treasury informally.
The model is also candid about its limits. Deposit insurance can tempt banks to take excessive risks at taxpayers’ expense, which is why regulators pair it with rules on capital and borrowing.
Why it matters
The Diamond–Dybvig model underpins deposit insurance and central bank emergency lending, which protect ordinary people’s savings and keep bank panics from turning into depressions.
About Douglas Diamond
Chicago economist whose Diamond–Dybvig model explains bank runs and why deposit insurance protects savers, the basis of modern bank regulation. Nobel Prize 2022.
Sources
- Popular information: The Prize in Economic Sciences 2022 NobelPrize.org
- Douglas Diamond, Biographical NobelPrize.org
- Douglas Diamond Wikipedia
Another act of tikkun olam. This is part of tikkun olam, the Jewish idea of repairing the world, and every one of us can add to it.