This chapter reviews the modern theoretical literature on banking and bank runs. In particular, it examines the three leading modern theories of banking in the academic literature, and it identifies problems with each of them. One of these theories, sometimes called the “risk sharing” theory, receives special attention because it forms the basis for the canonical model of bank runs: the famous Diamond-Dybvig model. The chapter offers a critique of this model on the basis of its underlying theory of banking, which is essentially nonmonetary. Next, the chapter argues that financing structure “matters” for banks in a way that it does not for other firms—a proposition that has recently been challenged by prominent financial economists. The chapter concludes with a fairly detailed account of the shadow banking panics of 2007 and 2008. It shows how the analysis of the first three chapters provides a framework for understanding these events.
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