We’ve had global banking crises before, and we will almost surely have them again. However, thanks to the research of Douglas Warren Diamond, we are more prepared to handle them than ever before. Diamond looked at what causes banks to collapse, how to prevent this, and how even rumours about this collapse can affect the entire process.
The roots of modern banking can be traced back to the European Renaissance, and ever since, banks have become more complex and intertwined with both people’s and countries’ finances. Diamond addressed a recurring problem that banks face: bank runs, which occur when numerous clients simultaneously panic and withdraw their funds. In addition, banks raise most of their funding in the form of debt (deposits) and have very high levels of leverage as a result.
Banks commonly pool small deposits together to offer larger, long-term loans, while also maintaining enough liquidity to meet regular withdrawal demands. If depositors behave normally, this allows banks to function efficiently, keeping only a small fraction of deposits in reserve while lending out the rest for long-term investments. However, this also introduces a vulnerability. Bank runs can become self-fulfilling prophecies: if depositors believe others will withdraw their funds (i.e. if they think the bank is failing), their only rational response is to withdraw as well, even if the bank is objectively healthy.
In 1983, Douglas Diamond and Philip Dybvig introduced a model that would revolutionize the understanding of bank runs, addressing this vulnerability. Diamond and Dybvig argued that allowing banks to fail during a run is rarely optimal. Instead, deposit insurance from the government is more efficient. This can ensure that banks will not impose losses on depositors even during a run, which negates the people’s motivation to participate in the bank run in the first place. This model explains why, even for stable banks, protections like deposit insurance can prevent unnecessary financial crises. The model was first published in 1983 and is widely regarded as a seminal contribution to the field. It shows why bank deposits can be more liquid than their illiquid assets, and this creation of liquidity is both desirable and potentially unstable.
Previous work from Diamond’s 1980 doctoral dissertation, published in 1984, showed why banks can make loans to business borrowers who need monitoring while raising funds from depositors who do not monitor the bank. This model shows that this delegated monitoring requires banks to raise its funds in the form of debt deposits. For this to work well, the bank must lend to a diversified set of borrowers. This shows how the special type of loans made by banks (those needing monitoring), dictate the form of funding it should get from depositors.
These insights were especially relevant during the 2008 financial crisis when fears of insolvency triggered liquidity shortages and bank failures. Governments and central banks responded by bailing out key financial institutions and by providing emergency liquidity, all measures consistent with the model’s recommendations to prevent systemic collapse.
Diamond was born on 25 October 1953 in Chicago, USA. He originally intended to study molecular biology but shifted to economics, graduating from Brown University with a Bachelor of Arts degree in economics in 1975. He joined the PhD program in Economics at Yale in 1975 and was awarded his doctorate in 1980. Both he and Nobel co-recipient Philip H. Dybvig were advised by Stephen A. Ross. Since 1979, he has taught at the University of Chicago Booth School of Business. He is married to Elizabeth Cammack Diamond and has two children.
