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Dd Model And The Size Of It's Jingus

1366 words - 6 pages

Diamond – Dybvig Model

The Diamond–Dybvig model was created by Douglas Diamond and Philip Dybvig in order to explain why banks issue deposits that are much more liquid then the assets. This conflict of liquidity occurs because banks typically make loans that cannot be sold at a high prices and cannot be collected very quickly, but issue demand deposits to its customers which can be withdrawn at any time. The Diamond–Dybvig model argues that a primary function of banks is to create liquidity (offer deposits more liquid than assets they hold) because investors who have a demand for liquidity will invest with banks rather than hold assets directly.
Before discussing how banks create ...view middle of the document...

28 to people who withdraw at T1. Let’s say that at T1, 25 customers withdraw 1.28 each causing the bank to have to liquidate 25 x $1.28 = $32 of assets. If 32% of the bank’s portfolio is liquidated to pay back depositors, than 68% of the remaining assets will be left within the bank until T2. At that point in time, the remaining portfolio value will mean that the remaining 75 customers will receive $1.813. Essentially, a bank can provide the more liquid asset which has a smaller loss from liquidating early as opposed to if the investor held the illiquid assets directly. For example, the bank provides a fraction (t) of investors (r1) at a point in time (T1) which leaves a fraction (1-tr1) of the assets available for customers to liquidate at T2. Essentially, when assets are illiquid and investors who have low risk thresholds are unaware of when they will need to liquidate, a bank can create a more liquid asset that enables investors to share the risk of losses from liquidation.
While the D-D model creates value to society by mitigating risk of liquidation losses, the model also illustrates a potential problem. The D-D model, as explained above, depends entirely on a fraction of a bank’s total portfolio remaining in reserves at any point in time. Because banks create liquidity by offering deposits that are more liquid than their assets, there might come a point in time where banks run into liquidity issues. In other words, a large number of people demand their deposits at one time and the bank is unable to meet those requests because the investor’s money is tied up in illiquid assets. This is called a “bank run”. For instance, let us assume that fictional ABC Bank currently has $10 million in its portfolio. If we follow the D-D model, we can assume that a certain percentage of investors will request their money at a time T1 while the remaining percentage of investors will continue to keep their money in the bank allowing the bank to invest in less liquid assets while retaining their ability to pay back the investors at time T2. Let us say that depositors of ABC Bank were made aware of the fact that the bank has been reporting large for a few quarters now and has a significant chance to go bankrupt in the next year. This news causes a widespread distrust in the ability of ABC Bank to handle depositor money and will inevitably cause hundreds of ABC Bank customers to withdraw money out of the bank at the same time. ABC Bank does not have the cash reserves to pay back every depositor’s cash demand and must resort to liquidate many of their illiquid assets at a discount in order to pay customer’s back. In essence, bank runs are a self-fulfilling prophecy. Although ABC Bank was projected to go bankrupt in the future, there was still a chance for the bank to recover in the coming year. By removing all their money at the...

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