Recent Models of Banking Instability

We end our present treatment of banking by considering some recent theoretical work on banking instability. This work has attracted considerable attention, and purports to provide rigorous theoretical justifications for government deposit insurance and other features of modern central banking. The key paper in this new literature is Diamond and Dybvig (hereafter DD, 1983). This paper posed two questions that have dominated the subsequent literature. First, why are financial institutions subject to instability and, as a subsidiary question, why is this instability damaging? Second, what, if anything, should the government or central banking authorities do about this instability? DD suggested that the instability arises because depositors’ liquidity demands are uncertain and banks’ assets are less liquid than their liabilities, and they suggest that the instability is harmful because it ruins risk-sharing arrangements and damages production. They also argued that this instability creates a need for government deposit insurance or a lender of last resort to provide emergency loans to banks. Later literature in the DD tradition develops these answers further and has been used to justify additional policies such as interest-rate ceilings (e.g., Anderlini, 1986b; Smith, 1984) and reserve requirements (e.g., Freeman, 1988).