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Liquidity Mismatch and Bank Runs.

Set reserves and early withdrawals before liquidating a long asset at a discount.

Interactive experimentintuitiveField note ·
INTERACTIVE EXPERIMENT / P54

Liquidity Mismatch and Bank Runs

Set reserves and early withdrawals before liquidating a long asset at a discount.

TEST THE MECHANISM

Fifty deposits of one fund cash reserves and a long asset. Each invested unit pays 1.5 at maturity but only 0.5 if liquidated early. Choose total early withdrawal requests and inspect the balance sheet.

050
050

More early withdrawals can destroy value through liquidation. This balance-sheet scenario omits strategic beliefs, deposit insurance, central-bank support, credit losses and real institutions; it is not a bank solvency assessment.

This balance-sheet scenario omits strategic beliefs, insurance, central-bank support and actual institutions. It is neither a full Diamond–Dybvig equilibrium nor a solvency forecast.

THE SHORT VERSION

Liquidity Mismatch and Bank Runs, explained.

Liquidity mismatch arises when short-notice liabilities fund assets that cannot be converted to cash quickly at their full longer-term value.

01 / THE MECHANISM

Why it happens

Fifty unit deposits fund cash and a long asset returning 1.5 at maturity but 0.5 under early liquidation. Early requests trigger liquidation, and the remaining balance sheet determines later assets per unpaid claim.

Liquidity mismatch arises when short-notice liabilities fund assets that cannot be converted to cash quickly at their full longer-term value.

Read the result

Unpaid early claims remain among remaining claims. Maturity assets reflect any long holdings destroyed by early liquidation, not their original eventual payoff.

02 / FOLLOW IT THROUGH

A worked example

Meet early claims by selling long assets cheaply

  1. Choose reserves ten and early withdrawals ten, leaving the long asset intact.

  2. Set early requests thirty and settle, requiring liquidation of all forty long-asset units at one-half each.

  3. Compare maturity assets per remaining claim with the first scenario, keeping strategic run beliefs outside this balance-sheet exercise.

OPTIONAL DEEPER DETAILGo deeper: inside the model

Inside this model

Fifty unit deposits fund cash and a long asset returning 1.5 at maturity but 0.5 under early liquidation. Early requests trigger liquidation, and the remaining balance sheet determines later assets per unpaid claim.

03 / BEYOND THE EXPERIMENT

Where this idea is useful

A practical use

Separate an asset’s eventual payoff from the cash available to meet immediate withdrawals.

CHECK YOUR INTUITION

A common misconception

THE TEMPTING CONCLUSION

“An asset with a positive eventual payoff can always meet immediate liabilities at that value.”

THE MORE USEFUL DISTINCTION

Timing and liquidation discounts matter: an asset’s maturity value does not necessarily provide enough cash for short-notice withdrawals.

What this explanation leaves out

  • This balance-sheet scenario omits strategic beliefs, insurance, central-bank support and actual institutions. It is neither a full Diamond–Dybvig equilibrium nor a solvency forecast.
ONE MORE QUESTION

Does this scenario identify which real bank will fail?

No. It omits actual balance sheets, insurance, central-bank access and strategic beliefs, so it cannot assess an institution’s solvency.

TAKE THE IDEA WITH YOU

What value is lost when a long asset must fund a claim earlier than planned?

Associated thinkers

Associated withDouglas Diamond ↗
Associated withPhilip Dybvig ↗

Associations marked provisional are awaiting source review.

Further reading

Explore the original research or the teaching reference behind this experiment.