Dybvig Ass.3.docx - Rahma Faisal 20617800 ECON 496 u2013...

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Rahma Faisal 20617800 ECON 496 – Assignment 3 Summary: In the article, “Bank runs, liquidity, and deposit insurance”, Diamond and Dybvig present a model that illustrates the idea that customers are willing to pay a bank to manage the risk of not being completely sure how soon they might require their savings. The banks provide a feasible contract to depositors that allows them to prevent runs and provide optimal risk sharing by converting illiquid assets to offer liabilities with a smoother pattern of returns over time. Diamond and Dybvig then argue that if investment projects are long-term, the banks are more vulnerable to runs. Bank runs cause real economic problems because even healthy banks can fail, causing the recall of loans and the termination of productive investment. Therefore, a bank that has deposit insurance can provide liquidity insurance to a firm, which can prevent a liquidity crisis for a firm with short-term debt and limit the firm’s need to use bankruptcy to stop such crises.

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