In his Nobel lecture, Diamond recalled a trip to Grand Teton National Park in 1981 with Dybvig, a former Yale University classmate. Displaying a photo of the two of them grinning in front of a mountain vista, Diamond said he and Dybvig batted around ideas and were very pleased about their discussion.
Diamond explained that he and Dybvig explored “why banks and intermediaries are good to have in the middle and why they use certain financial contracts. The financial contract we have in mind here is short-term debt. Why do banks use so much short-term debt to finance long-term illiquid assets, which, in turn, turns out to leave them subject to bank runs?”
They co-authored “Bank Runs, Deposit Insurance and Liquidity,” which appeared in the Journal of Political Economy in 1983. The groundbreaking paper introduced the Diamond-Dybvig model, a framework that explains the factors that cause bank runs, outlines the consequences of such failures, and explores ways to stop them from happening.
The point of the paper, Diamond said, was that “we’re going to assume that the bank’s assets are long term, safe if you hold them to maturity, but illiquid.”
In another influential paper, “Financial Intermediation and Delegated Monitoring,” which was based on his Ph.D. dissertation that appeared in The Review of Economic Studies in 1984, Diamond argued that banks play a critical role in evaluating whether borrowers are worth the risk of a loan and then monitoring them to make sure they repay their debts. Together, the two papers have had a significant impact on economic thinking and policymaking around financial crises.
Diamond and Dybvig forged a new path when they proposed that banks specialized in creating liquid claims against illiquid assets. Banks, in the authors’ view, allowed their customers to hedge the need to access funds on short notice. In this interpretation, banks didn’t provide access to proprietary investment opportunities; rather, they created value through the structure of the bank liabilities that they offered to their customers.
Banks improved upon the outcomes that individual depositors could achieve by investing elsewhere by recognizing that while each depositor may have uncertain liquidity demands, few would need money on short notice. By pooling many of the deposits, the banks essentially offered insurance—they gave each depositor the right to withdraw those deposits upon demand, while relying on the fact that few depositors would need to do so.
“Private financial crises are everywhere and always due to the problems of short-term debt,” Diamond said. “Short-term debt runs are what bring down these panic, self-fulfilling prophecy failures.”
—This story includes content previously published on the Chicago Booth website.