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The collapse of the Silicon Valley Bank (SVB) and a few other banks has once again drawn attention to the need for better methods and institutions in financial economic policy.
Banks have suffered from runs right from the earliest times. Our thorough understanding of bank runs comes from Douglas W Diamond and Philip H Dybvig, who in 1983 obtained deep insights into the fundamental paradox of banking and won the 2022 Nobel Prize for this work. Banks are repositories for consumers’ cash. The cash in turn is put to use by banks. However, banks make investments with that cash and generate income, and this tends to tie up money, which cannot be immediately liquidated.
In normal times, this is a good way to create wealth, but it can lead to a crisis if everyone panics and tries to withdraw all their funds at the same time. To quote Professor Diamond “[The system] is very vulnerable to the fear of fear”. Banks are intrinsically illiq
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