On the fundamental reasons for bank fragility

Economic Quarterly 01/2010;
Source: RePEc

ABSTRACT A substantial body of literature has now developed as a result of efforts to identify the fundamental reasons for the fragility of financial intermediaries in the Diamond-Dybvig theory of banking. Many of these articles focus on the interaction between sequential service and uncertainty about the aggregate need for liquidity in the economy. The articles in this literature are inevitably technical and focus somewhat narrowly on the implications of specific assumptions. Here, we provide a more accessible discussion of the main ideas and findings in this literature. Our discussion can be used as an introduction to the more technical articles or as an organizing framework for understanding the relative contribution of the main articles in this literature.

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    ABSTRACT: Sequential service in the banking sector, as modeled by Diamond and Dybvig (1983), is a barrier to full insurance and potential source of financial fragility against which deposit insurance is infeasible (Wal-lace, 1988). In this paper, we pursue a different perspective, view-ing the sequence of contacts as opportunities to extract information through a larger message space with commitment to richer promises. As we show, if preferences satisfy a separating property then the de-sired elimination of dominated strategies (Green and Lin, 2003) occurs even when shocks are correlated. In this manner the sequential service promotes stability.


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