European Debt Crisis and the Diamond and Dybvig's Model (Bank Runs)

The current European Debt Crisis goes as follows: Some countries are at risk of default (Italy, Portugal, Spain) or have already defaulted on part of their debt (Greece). European financial institutions (Banks) are heavily invested in sovereign bonds. Fearing sovereign defaults, banks have cut down their investments on sovereign  bonds, drying up government funding and increasing their borrowing rates. This, in turn, makes the default scenario more likely for some countries which have to refinance their debt at higher interest rates. However, banks still have a great amount of investments in such suspected-to-default countries. They can  get rid of troubled sovereign bonds ut only at fire-sales  prices.

The Diamond and Dybvig's model helps understanding the situation. Governments are like banks, they take money from banks and private investors  (as banks do from depositors), expend it (like banks make loans), and hope to repay  (as banks hope to repay depositors) with tax revenues (equivalent to banks revenues from loans). When banks and private investors (depositors) fears that governments won't have enough tax income to repay, they withdraw their deposits, not by actually withdrawing money, but by stopping future debt refinancing to suspected-to-default governments.

In essence, the European Debt Crisis has the same ingredients that a regular bank run scenario. However, bankers are now depositors, and governments are the bankers. How to stop a bank run? 1) Create deposit insurance or 2) Let a lender of last resort step in.  Since the European Central Bank (ECB) can not directly lend to governments (the now bankers) it can not act as a lender of last resort for them. However, the newly announced program to lend generously to banks at very low interest rates allows the ECB to essentially act as the lender of last resort governments (bankers) need. The ECB rejected proposals to create an emergency deposit insurance for governments (bankers).  It did so by not buying trouble assets directly. Instead, it will lend money to regular banks, hoping these banks will buy trouble assets at higher interest rates and make a profit. Banks secure the ECB loans by putting the assets they will buy as collateral.

This is like giving depositors money to invest in banks when the likelihood of a bank run increases. Depositors secure these loans offering their risky deposits as collateral. However, it is not clear how this strategy will play out. I think the ECB strategy is novel in the sense that it gives depositors (read banks) long-term loans so that they can mitigate the need to run the suspected-to-default governments. In the Diamond and Dybvig model, depositors run the banks when they suspect the bank won't have enough to repay them and decide they have a better chance to be repaid by running to the bank.

Certainly, it buys some time for governments (bankers) to reduce their deficits alleviating short term pressures. However, banks may not follow through the strategy and they can divest the newly available money to substitute their risky assets for safer ones.