Diamond-Dybvig and Beyond: On the Instability of Banking

Gu, Chao; Monnet, Cyril; Nosal, Ed; Wright, Randall

doi:10.29338/wp2023-02

Working Paper

Diamond-Dybvig and Beyond: On the Instability of Banking

Abstract: Are financial intermediaries—in particular, banks—inherently unstable or fragile, and if so, why? We address this question theoretically by analyzing whether model economies with financial intermediation are more prone than those without it to multiple, cyclic, or stochastic equilibria. We consider several formalizations: insurance-based banking, models with reputational considerations, those with fixed costs and delegated investment, and those where bank liabilities serve as payment instruments. Importantly for the issue at hand, in each case banking arrangements arise endogenously. While the economics and mathematics differ across specifications, they all predict that financial intermediation engenders instability in a precise sense.

Keywords: banking; financial intermediation; instability; volatility;

JEL Classification: D02; E02; E44; G21;

https://doi.org/10.29338/wp2023-02

Status: Published in 2023