D

iamond and Dybvig

The model was published in 1983 by Douglas W. Diamond of the University of

Chicago and Philip H. Dybvig, then of Yale University.

Introduction

The Diamond-Dybvig model uses game theory to provide an explanation of the

provision of liquidity by a bank, and of the circumstances under which the
demand for liquidity can lead to a bank run.
For the purpose of the model, a bank is treated as an intermediary between
borrowers who want long-term loans for the purpose of investment, and savers
who have unpredictable needs for immediate access to cash.
Since the unpredictable needs of different savers are unlikely to coincide, a small
proportion of its receipts is normally sufficient to meet those needs. However, if
enough depositors attempt to make simultaneous withdrawals, the bank may be
unable to pay them all.
Among the findings of the model is the conclusion that the provision of deposit
insurance is a more efficient way of preventing bank runs than the alternative of
suspending withdrawals until sufficient funds can be raised to pay them.

The Model

Banks make loans that cannot be sold quickly at a high price.

Reason??
Business investments often require expenditures in the present to procure
returns in the future (for example, spending on machines and buildings in the
present period for production in future years). Therefore, when businesses
need to borrow to finance their investments, they prefer loans with a long
maturity (that is, low liquidity).
Banks accept demand deposits that allow depositors to withdraw at any time.
Thus, there is a tension between the needs of individual savers - who
want ready access to their funds in case a sudden need arises - and the
requirements of productive investment, which requires sustained commitment
of resources. Banks have accepted demand deposits throughout their
history. In this role, banks can be viewed as providing insurance that
allows agents to consume when they need the most.
Individual savers may have sudden, unexpected, unpredictable needs for
cash, due to unforeseen expenditures. So they demand liquid accounts which
permit them immediate access to their deposits (high liquidity).
Banks act as intermediaries between savers who prefer to deposit in liquid
accounts and borrowers who prefer to take out long-maturity loans.
Since banks provide a valuable service to both sides (providing the long-
maturity loans businesses want and the liquid accounts depositors want), they
can charge a higher interest rate on loans than they pay on deposits and thus
profit from the difference.
Individual expenditure needs are largely uncorrelated; by the law of large
numbers, banks expect few withdrawals on any given day. As long as
all depositors do not withdraw their deposits at the same time, the bank
expects only a small fraction of withdrawals in the short term, even
though all depositors have the right to take their deposits back at any time.
Thus, a bank can make loans over a long horizon, while keeping only
relatively small amounts of cash on hand to pay any depositors that wish to
make withdrawals. The problem, of course, is the vulnerability of such a
system to self-fulfilling panics: if people believe that a bank will fail,
everyone will in fact want to withdraw funds at the same time — and
because the bank’s assets are illiquid,
 trying to meet those demands through fire sales can in fact cause the bank to
fail.

Nash Equilibria of the Model

In a nutshell, the model depicts fractional-reserve banks as intermediaries
dealing in illiquid assets and liquid liabilities and depicts the relationship
among depositors as a coordination game with two Nash equilibria, one in
which nobody tries to withdraw his/her funds because he/she believes no one
else will try to withdraw his/her funds, and one in which everyone tries to
withdraw their funds because they believe everyone else will try to withdraw
their funds.
The mismatch of liquidity, in which a bank’s liabilities are more liquid than its
assets, may cause problems for banks when too many depositors attempt to
withdraw at once (a situation referred to as a bank run).
This means that even healthy banks are potentially vulnerable to panics,
usually called bank runs.

What Next?
Banks faced with bank runs often shut down and refuse to permit more than a
few withdrawals, which is called suspension of convertibility.
While this may prevent some depositors who have a real need for cash from
having access to their money, it also prevents immediate bankruptcy, thus
allowing the bank to wait for its loans to be repaid, so that it has enough
resources to pay back some or all of its deposits.

Deposit Insurance
Suspension of convertibility cannot be an optimal mechanism for preventing
bank runs.
Diamond and Dybvig argue that a better way of preventing bank runs is deposit
insurance backed by the government or central bank.
 Such insurance pays depositors all or part of their losses in the case of a
bank run.
However, if depositors know that they will get their money back even in case
of a bank run, they have no reason to participate in a bank run.
Thus, sufficient deposit insurance can eliminate the possibility of bank runs.
In principle, maintaining a deposit insurance program is unlikely to be very
costly for the government: as long as bank runs are prevented, deposit
insurance will never actually need to be paid out.

“Too big to fail”

Addressing the question of whether Too Big to Fail is a useful focus for bank regulation,
Nobel laureate Paul Krugman wrote:
My basic view is that banking, left to its own devices, inherently poses risks of
destabilizing runs; I’m a Diamond-Dybvig guy. To contain banking crises, the
government ends up stepping in to protect bank creditors. This in turn means that you
have to regulate banks in normal times, both to reduce the need for rescues and to limit
the moral hazard posed by the rescues when they happen.
And here’s the key point: it’s not at all clear that the size of individual banks makes
much difference to this argument.

I
NDIAN SCENARIO

In India, the deposit insurance backed by RBI is provided by Deposit Insurance and
Credit Guarantee Corporation (DICGC), a subsidiary of Reserve Bank of India

History (read through the history just to know the background of DICGC; need
not remember the same)
The concept of insuring deposits kept with banks received attention for the first time in
the year 1948 after the banking crises in Bengal. The question came up for
reconsideration
in the year 1949, but it was decided to hold it in abeyance till the Reserve Bank of India
ensured adequate arrangements for inspection of banks. Subsequently, in the year
1950, the Rural Banking Enquiry Committee also supported the concept. Serious
thought to the concept was, however, given by the Reserve Bank of India and the
Central Government after the crash of the Palai Central Bank Ltd., and the Laxmi Bank
Ltd. in 1960. The Deposit Insurance Corporation (DIC) Bill was introduced in the
Parliament on August 21, 1961. After it was passed by the Parliament, the Bill got the
assent of the President on December 7, 1961 and the Deposit Insurance Act, 1961
came into force on January 1, 1962.
The Deposit Insurance Scheme was initially extended to functioning commercial banks
only. This included the State Bank of India and its subsidiaries, other commercial banks
and the branches of the foreign banks operating in India.

Since 1968, with the enactment of the Deposit Insurance Corporation (Amendment) Act,
1968, the Corporation was required to register the 'eligible co-operative banks' as
insured banks under the provisions of Section 13 A of the Act. An eligible co-operative
bank means a co-operative bank (whether it is a State co-operative bank, a Central co-
operative bank or a Primary co-operative bank) in a State which has passed the
enabling legislation amending its Co-operative Societies Act, requiring the State
Government to vest power in the Reserve Bank to order the Registrar of Co-operative
Societies of a State to wind up a co-operative bank or to supersede its Committee of
Management and to require the Registrar not to take any action for winding up,
amalgamation or reconstruction of a co- operative bank without prior sanction in writing
from the Reserve Bank of India.

Further, the Government of India, in consultation with the Reserve Bank of India,
introduced a Credit Guarantee Scheme in July 1960. The Reserve Bank of India was
entrusted with the administration of the Scheme, as an agent of the Central
Government, under Section 17 (11 A)(a) of the Reserve Bank of India Act, 1934 and
was designated as the Credit Guarantee Organization (CGO) for guaranteeing the
advances granted by banks and other Credit Institutions to small scale industries. The
Reserve Bank of India operated the scheme up to March 31, 1981.
The Reserve Bank of India also promoted a public limited company on January 14,
1971, named the Credit Guarantee Corporation of India Ltd. (CGCI). The main thrust of
the Credit Guarantee Schemes, introduced by the Credit Guarantee Corporation of India
Ltd., was aimed at encouraging the commercial banks to cater to the credit needs of the
hitherto neglected sectors, particularly the weaker sections of the society engaged in
non- industrial activities, by providing guarantee cover to the loans and advances
granted by the credit institutions to small and needy borrowers covered under the
priority sector.
With a view to integrating the functions of deposit insurance and credit guarantee, the
above two organizations (DIC & CGCI) were merged and the present Deposit Insurance
and Credit Guarantee Corporation (DICGC) came into existence on July 15, 1978.
Consequently, the title of Deposit Insurance Act, 1961 was changed to 'The Deposit
Insurance and Credit Guarantee Corporation Act, 1961 '.

Effective from April 1, 1981, the Corporation extended its guarantee support to credit
granted to small scale industries also, after the cancellation of the Government of India's
credit guarantee scheme. With effect from April 1, 1989, guarantee cover was extended
to the entire priority sector advances, as per the definition of the Reserve Bank of India.
However, effective from April 1, 1995, all housing loans have been excluded from the
purview of guarantee cover by the Corporation.

H OW DOES DEPOSIT INSURANCE WORK?

1. Which banks are insured by the DICGC?

Commercial Banks: All commercial banks including branches of foreign banks
functioning in India, local area banks and regional rural banks are insured by the DICGC.
Cooperative Banks: All State, Central and Primary cooperative banks, also called urban
cooperative banks, functioning in States / Union Territories which have amended the
local Cooperative Societies Act empowering the Reserve Bank of India (RBI) to order the
Registrar of Cooperative Societies of the State / Union Territory to wind up a cooperative
bank or to supersede its committee of management and requiring the Registrar not to
take any action regarding winding up, amalgamation or reconstruction of a co-operative
bank without prior sanction in writing from the RBI are covered under the Deposit
Insurance Scheme. At present all co-operative banks other than those from the State of
Meghalaya and the Union Territories of Chandigarh, Lakshadweep and Dadra and
Nagar Haveli are covered by the DICGC.
Primary cooperative societies are not insured by the DICGC.

2. What does the DICGC insure?

The DICGC insures all deposits such as savings, fixed, current, recurring, etc. deposits
except the following types of deposits
i. Deposits of foreign Governments;
ii. Deposits of Central/State Governments;
iii. Inter-bank deposits;
iv. Deposits of the State Land Development Banks with the State co-operative bank;
v. Any amount due on account of and deposit received outside India
vi. Any amount, which has been specifically exempted by the corporation with
the previous approval of Reserve Bank of India

3. What is the maximum deposit amount insured by the DICGC?

Each depositor in a bank is insured up to a maximum of 1,00,000 (Rupees One Lakh)
for both principal and interest amount held by him in the same right and same capacity
as on the date of liquidation/cancellation of bank's license or the date on which the
scheme of amalgamation/merger/reconstruction comes into force.

4. How will you know whether your bank is insured by the DICGC or not?
The DICGC while registering the banks as insured banks furnishes them with printed
leaflets for display giving information relating to the protection afforded by the
Corporation to the depositors of the insured banks. In case of doubt, depositor should
make specific enquiry from the branch official in this regard.
5. What is the ceiling on amount of Insured deposits kept by one person in
different branches of a bank?
The deposits kept in different branches of a bank are aggregated for the purpose of
insurance cover and a maximum amount up to rupees one lakh is paid.

6. Does the DICGC insure just the principal on an account or both principal and
accrued interest?
The DICGC insures principal and interest upto a maximum amount of one lakh. For
example, if an individual had an account with a principal amount of 95,000 plus accrued
interest of 4,000, the total amount insured by the DICGC would be 99,000. If, however,
the principal amount in that account was one lakh, the accrued interest would not be
insured, not because it was interest but because that was the amount over the
insurance limit.

7. Can deposit insurance be increased by depositing funds into several different

accounts all at the same bank?
All funds held in the same type of ownership at the same bank are added together
before deposit insurance is determined. If the funds are in different types of ownership
or are deposited into separate banks they would then be separately insured.

8. Are deposits in different banks separately insured?

Yes. If you have deposits with more than one bank, deposit insurance coverage limit is
applied separately to the deposits in each bank.

9. If you have funds on deposit at two different banks, and those two banks
are closed on the same day, are your funds added together, or insured
separately? Your funds from each bank would be insured separately, regardless of the
date of closure.

10. What is the meaning of deposits held in the same capacity and same right; and
deposits held in different capacity and different right?
If an individual opens more than one deposit account in one or more branches of a bank
for example, Shri S.K. Pandit opens one or more savings/current account and one or
more fixed/recurring deposit accounts etc., all these are considered as accounts held in
the same capacity and in the same right. Therefore, the balances in all these accounts
are aggregated and insurance cover is available up to rupees one lakh in maximum.
If Shri S.K. Pandit also opens other deposit accounts in his capacity as a partner of a
firm or guardian of a minor or director of a company or trustee of a trust or a joint
account, say with his wife Smt. K. A. Pandit, in one or more branches of the bank then
such accounts are considered as held in different capacity and different right.
Accordingly, such deposits accounts will also enjoy the insurance cover up to rupees
one lakh separately.
It is further clarified that the deposit held in the name of the proprietary concern where a
depositor is the sole proprietor and the amount of Deposit held in his individual capacity
are aggregated and insurance cover is available up to rupees one lakh in maximum.

Illustrations

Saving Current FD Total Deposits

s A/C A/C Deposits Insured upto
A/C
Shri S. K. Pandit 17,200 22,000 80,000 1,19,200 1,00,000
(Individual)
Shri S. K. Pandit 75,000 50,000 1,25,000 1,00,000
(Partner of ABC &
Co.)
Shri S. K. Pandit 7,800 80,000 87,800 87,800
(Guardian for Master
Ajit)
Shri S. K. Pandit 2,30,000 45,000 2,75,000 1,00,000
(Director, J.K. Udyog
Ltd.)
Shri S. K. Pandit jointly 7500 1,50,000 50000 2,07,500 1,00,000
with Smt. K. A. Pandit
Deposits held in joint accounts (revised w.e.f. April 26, 2007)
If more than one deposit accounts (Savings, Current, Recurring or Fixed deposit) are
jointly held by individuals in one or more branch of a bank say three individuals A, B & C
hold more than one joint deposit accounts in which their names appear in the same
order then all these accounts are considered as held in the same capacity and in the
same right. Accordingly, balances held in all these accounts will be aggregated for the
purpose of determining the insured amount within the limit of 1 lakh.
However, if individuals open more than one joint accounts in which their names are not
in the same order for example, A, B and C; C, B and A; C, A and B; A, C and B; or
group of persons are different say A, B and C and A, B and D etc. then, the deposits
held in these joint accounts are considered as held in the different capacity and different
right. Accordingly, insurance cover will be available separately up to rupees one lakh to
every such joint account where the names appearing in different order or names are
different.
Illustrations
Account (i) First a/c holder- Maximum insured amount up
(Savings or Current A/C) "A" to 1 lakh
Second a/c
holder - "B"
Account (ii) First a/c holder - Maximum insured amount up to
"A" 1 lakh
Second a/c holder
- "C"
Account (iii) First a/c holder - Maximum insured amount up to
"B" 1 lakh
Second a/c holder
- "A"
Account (iv) at Branch ‘X’ of First a/c holder - Maximum insured amount up to
the bank "A" 1 lakh
Second a/c holder
- "B"
Third a/c holder -
"C"
Account (v) First a/c holder - Maximum insured amount up to
"B" 1 lakh
Second a/c holder
- "C"
Third a/c holder -
"A"
Account First a/c holder - The account will be clubbed with
(vi)( (Recurring or Fixed "A" the a/c at (i)
Deposit) Second a/c holder
- "B"
Account (vii) First a/c holder - The account will be clubbed with
At Branch ‘Y’ of the bank "A" the a/c at (iv)
Second a/c holder
- "B"
Third a/c holder -
"C"
Account (viii) First a/c holder - Maximum insured amount up to
"A" 1 lakh
Second a/c holder
- "B"
Third a/c holder -
"D"
11. Who pays the cost of deposits insurance?
Deposit insurance premium is borne entirely by the insured bank.

12. When is the DICGC liable to pay?

If a bank goes into liquidation: The DICGC is liable to pay to each depositor through the
liquidator, the amount of his deposit up to rupees one lakh within two months from the
date of receipt of claim list from the liquidator.
If a bank is reconstructed or amalgamated / merged with another bank: The DICGC
pays the bank concerned, the difference between the full amount of deposit or the limit
of insurance cover in force at the time, whichever is less and the amount received by
him under the reconstruction / amalgamation scheme within two months from the date
of receipt of claim list from the transferee bank / Chief Executive Officer of the insured
bank/transferee bank as the case may be.

13. Does the DICGC directly deal with the depositors of failed banks?
No. In the event of a bank's liquidation, the liquidator prepares depositor wise claim list
and sends it to the DICGC for scrutiny and payment. The DICGC pays the money to the
liquidator who is liable to pay to the depositors. In the case of amalgamation / merger of
banks, the amount due to each depositor is paid to the transferee bank.

14. Can any insured bank withdraw from the DICGC coverage?
No. The deposit insurance scheme is compulsory and no bank can withdraw from it.

15. Can the DICGC withdraw deposit insurance coverage from any bank?
The Corporation may cancel the registration of an insured bank if it fails to pay the
premium for three consecutive periods. In the event of the DICGC withdrawing its
coverage from any bank for default in the payment of premium the public will be notified
through newspapers.
Registration of an insured bank stands cancelled if the bank is prohibited from receiving
fresh deposits; or its license is cancelled or a license is refused to it by the RBI; or it is
wound up either voluntarily or compulsorily; or it ceases to be a banking company or
a
co-operative bank within the meaning of Section 36A(2) of the Banking Regulation Act,
1949; or it has transferred all its deposit liabilities to any other institution; or it is
amalgamated with any other bank or a scheme of compromise or arrangement or of
reconstruction has been sanctioned by a competent authority and the said scheme does
not permit acceptance of fresh deposits. In the event of the cancellation of registration
of a bank, deposits of the bank remain covered by the insurance till the date of the
cancellation.

16. What will be the Corporation’s liability to the banks on de-registration.

The Corporation has deposit insurance liability on liquidation etc. of "Insured banks" i.e.
banks which have been de-registered (a) on account of prohibition on receiving fresh
deposits or (b) on cancellation of license or it is found that license cannot be granted.
The liability of the Corporation in these cases is limited to the extent of deposits as on
the date of cancellation of registration of bank as an insured bank.
On liquidation etc. of other de-registered banks i.e. banks which have been de-
registered on other grounds such as nonpayment of premium or their ceasing to be
eligible co- operative banks under section 2(gg) of the DICGC Act, 1961, the
Corporation will have no liability.
Note: Information given above is to convey the basic provisions of the deposit
insurance scheme of the Corporation. The information is of a non-technical nature and
is not intended to be a legal interpretation of the deposit insurance scheme.