Diamond–Dybvig model

The model shows how banks' mix of illiquid assets (such as business or mortgage loans) and liquid liabilities (deposits which may be withdrawn at any time) may give rise to self-fulfilling panics among depositors.

Diamond and Dybvig, along with Ben Bernanke, were the recipients of the 2022 Nobel Prize in Economics for their work on the Diamond-Dybvig model.

A similar basic concept had formed part of the nineteenth century British Banking School theory of financial crises.

[3] Diamond and Dybvig's paper points out that business investment often requires expenditures in the present to obtain returns in the future.

On the other hand, individual savers (both households and firms) may have sudden, unpredictable needs for cash, due to unforeseen expenditures.

Under ordinary circumstances, banks can provide a valuable service by channeling funds from many individual deposits into loans for borrowers.

However, Diamond and Dybvig argue that unless the total amount of real expenditure needs per period is known with certainty, suspension of convertibility cannot be the optimal mechanism for preventing bank runs.