A bank run occurs when a large number of customers withdraw their deposits from a
financial institution at the same time. This can destabilise the bank to the point where it runs
out of cash and thus faces sudden bankruptcy. As more people withdraw their deposits, the
likelihood of bankruptcy increases, thus triggering further withdrawals. In game theory this
type of situation can be modelled as a “coordination game”, that is, a game with two pure
equilibria: If sufficiently many people keep their money in the bank, then it will not default
and it is rational for everyone to keep their money in the bank. On the other hand, if sufficiently
many people withdraw their deposits the bank will default and it is then rational for everyone
to try to withdraw their deposits.
The overall objective of this study is to explain the phenomenon of bank runs by introducing
the Diamond–Dybvig model. This model assumes that the function of a bank is to
offer both long-term loans for investments and relatively short-term deposit service. Bank
runs comes out as one of two equilibria when too many withdraw early before the long-term
loans is paid back. Our task is to find out the condition that can lead to bank runs and more
importantly, we will suggest two ways to address the problem of bank runs.
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