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Diamond–Dybvig and beyond: On the instability of banking

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

Abstract

Are financial intermediaries – in particular, banks – inherently unstable or fragile, and if so, why? We address this theoretically by analyzing whether model economies with financial intermediation are more prone than those without it to multiple, cyclic, or stochastic equilibria. Several formalizations are considered: 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.

Suggested Citation

  • Gu, Chao & Monnet, Cyril & Nosal, Ed & Wright, Randall, 2023. "Diamond–Dybvig and beyond: On the instability of banking," European Economic Review, Elsevier, vol. 154(C).
    • Handle: RePEc:eee:eecrev:v:154:y:2023:i:c:s0014292123000430
    DOI: 10.1016/j.euroecorev.2023.104414
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    More about this item

    Keywords

    Banking; Financial intermediation; Instability; Volatility;
    All these keywords.

    JEL classification:

    • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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