Core Economic Definitions & Theoretical Mechanisms
Financial crises often stem from maturity mismatch: banks borrow short-term (deposits) and lend long-term (mortgages). The Diamond-Dybvig model shows how this makes banks inherently vulnerable to runs. If depositors panic and withdraw simultaneously, solvent but illiquid banks can fail. Contagion spreads through interbank lending and fire sales.
Underlying Mathematical Formulas & Equations
Illiquidity condition: Liquid Assets < Short-term Liabilities. Fire Sale Discount (d) = Asset Fundamental Value – Market Price during panic.
Concrete Worked Numerical Example
A bank has $100 in deposits and holds $10 in cash and $90 in illiquid loans. If 20 depositors demand their money, the bank exhausts its cash. It must sell loans quickly at a 30% discount. Selling $15 worth of loans yields only $10.50, accelerating insolvency.
Real-World Empirical Application: Historical Case Study
The 1930s Great Depression saw massive bank runs due to the lack of deposit insurance. More recently, the 2023 collapse of Silicon Valley Bank (SVB) demonstrated a modern digital bank run, where rapid withdrawals triggered by social media panic forced massive realized losses on long-term bonds.
Limitations, Criticisms, and Competing Schools of Thought
Critics of central bank interventions argue that acting as a lender of last resort or providing comprehensive deposit insurance creates moral hazard, encouraging banks to take excessive risks knowing they will be bailed out.
Comprehensive FAQ Section
What is systemic contagion?
The process where the failure of one financial institution triggers a chain reaction of failures due to interconnected liabilities and panic.
Academic References & Primary Source Citations
- Diamond, D. W., & Dybvig, P. H. (1983). Bank Runs, Deposit Insurance, and Liquidity.
- Bagehot, W. (1873). Lombard Street: A Description of the Money Market.