On October 10th, Douglas Diamond and Philip Dybvig won the Sveriges Riksbank Prize in Economic Sciences, sharing it with Ben Bernanke “for research on banks and financial crises.”
According to the prize committee, Diamond and Dybvig’s research showed how the combination of borrowing short and lending long exposes even sound banks to runs, since the merest rumor of a run can become “a self-fulfilling prophecy.” “These dangerous dynamics,” the committee wrote, “can be prevented through the government providing deposit insurance and acting as a lender of last resort to banks.”
Exactly one month later, on November 10th, FTX, the world’s second-largest cryptocurrency exchange, suspended redemptions following a wild three-day run during which its depositors withdrew $6 billion. A day later, FTX filed for bankruptcy, leaving its 100,000 remaining creditors with anywhere from $10 to $50 billion in unpaid debts, and throwing other cryptocurrency markets into disarray.
Predictably, the juxtaposition of these events caused many to treat the FTX embroglio as a perfect illustration, and further vindication (in case one was needed), of Diamond and Dybvig’s theory. On Twitter, Yale’s William Goetzmann, the author of Money Changes Everything, declared FTX’s collapse “A Diamond-Dybvig moment,” while Duke University’s Campbell Harvey, whose specialty is decentralized finance, called it “a classic Diamond-Dybvig bank run.” Matt Levine, writing for Bloomberg, likewise suggested that the mere fact that FTX lent (“repurposed”) its clients’ funds made it “vulnerable to runs, Diamond-Dybvig, It’s a Wonderful Life, etc., everyone knows all this.” Dozens of other reports labeled FTX’s troubles a “liquidity crisis,” which is of course the sort of crisis that makes banks go kaput according to Diamond and Dybvig’s famous article.
The problem with all of this is that FTX’s collapse doesn’t illustrate the Diamond-Dybvig story at all. Neither, for that matter, do most runs on commercial banks. And the difference between the sort of bank run Diamond and Dybvig describe, and most actual bank runs, including the one on FTX, is extremely important, for while government-mandated deposit insurance or public last resort lending may be the best ways to prevent or respond to a Diamond-Dybvig style run, other reforms, including market-based ones, are better suited to avoiding the sorts of runs that most often occur in the real world, including runs on cryptocurrency exchanges.
Of course, saying so is a lot easier than convincing you. That’s why this is a long post.
Read the rest of this post →