Financial Fragility and Bank Runs: Diamond-Dybvig Model and Deposit Insurance Design

Abstract

Bank runs—episodes in which depositors rush to withdraw funds from a bank, potentially causing it to fail even if it would have been solvent in the absence of the run—represent one of financial economics’ most important and enduring phenomena. Diamond and Dybvig’s (1983) Nobel Prize-winning model formalized the economics of bank fragility and bank runs, demonstrating that the maturity transformation function of banking—funding illiquid long-term loans with liquid short-term deposits—creates an inherently fragile structure susceptible to self-fulfilling runs. Deposit insurance, introduced in the U.S. through the Federal Deposit Insurance Corporation (FDIC) in 1933 following the 1930–1933 banking panics that destroyed one-third of U.S. banks, breaks the bank run equilibrium by guaranteeing deposits regardless of bank solvency—eliminating the incentive to run. The 2023 failures of Silicon Valley Bank, Signature Bank, and First Republic demonstrated that bank fragility remains a live concern even for well-capitalized banks when depositor coordination via social media enables near-instantaneous runs on uninsured deposits. This paper reviews the Diamond-Dybvig model, deposit insurance design, historical bank run episodes, and the evolving challenge of digital-age bank fragility.