Diamond and Dybvig’s Classic Theory of Financial Intermediation: What’s Missing?

Abstract

The article shows that in a finite-trader version of the Diamond and Dybvig model (1983), the ex ante efficient allocation can be implemented as a unique equilibrium. This is so even in the presence of the sequential service constraint, as emphasized by Wallace (1988), whereby the bank must solve a sequence of maximization problems as depositors contact it at different times. A three-trader example with constant relative risk-aversion utility is used in order to illustrate clearly the requirements that the sequential service constraint imposes on implementation.