Submitted by: Submitted by bluelotus007
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Category: Business and Industry
Date Submitted: 10/07/2014 03:57 PM
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be sold at a high prices and cannot be collected very quickly, but issue demand deposits to its customers which can be withdrawn at any time.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 liquidity, we must first understand why investors demand it. The main reason investors have a strong demand for liquidity is because of the uncertainty of their future consumption. Because of this, investors are unsure as to how long they need to hold their assets and would much know the value of liquidating assets at different periods of time rather than just one. The more liquid the asset, the lower expected rate of return. Investors who are risk-averse are willing to trade higher expected returns in order for more liquid assets. In other words, an investor’s demand for liquidity is greater the less risk he wishes to undertake which is exactly why the liquidity that a bank offers is so highly demanded.
A bank creates liquidity by offering demand deposits even though they invest in illiquid assets. For example, let us assume that in exchange for a deposit at T= 0, the bank offers to pay r1 = $1.28 for those who withdraw their money at T1 or r2 = $1.813 to those who withdraw at T2. If the bank receives $1 in deposits from a 100 customers, the bank’s portfolio is worth $100 at T0. If the bank wishes to loan out money (invest in an illiquid asset), it will also need to liquidate some of its illiquid assets in order to pay 1.28 to people who withdraw at T1. Let’s say that at T1, 25...