their deposits in, if they were not concerned about the bank failing. This can lead to failure of even 'healthy' banks and eventually an economy-wide contraction of liquidity, resulting in a full blown financial crisis. Diamond and Dybvig demonstrate that when banks provide pure demand deposit contracts, we can actually have multiple equilibria. If confidence is maintained, such contracts can actually improve on the competitive market outcome and provide better risk sharing. In such an equilibrium, a depositor will only withdraw when it is appropriate for him to do so under optimal risk-sharing. However, if agents panic, their incentives are distorted and in such an equilibrium, all depositors withdraw their deposits. Since liquidated assets are sold at a loss, therefore in this scenario, a bank will liquidate all its assets, even if not all depositors withdraw. Note that the underlying reason for withdrawals by depositors in the Diamond–Dybvig model is a shift in expectations. Alternatively, a bank run may occur because bank's assets, which are liquid but risky, no longer cover the nominally fixed liability (demand deposits), and depositors therefore withdraw quickly to minimize their potential losses. The model also provides a suitable framework for analysis of devices that can be used to contain and even prevent a liquidity crisis (elaborated below). Amplification mechanisms One of the mechanisms, that can work to amplify the effects of a small negative shock to the economy, is the balance sheet mechanism. Under this mechanism, a negative shock in the financial market lowers asset prices and erodes the financial institution's capital, thus worsening its balance sheet. Consequently, two liquidity spirals come into effect, which amplify the impact of the initial negative shock. In an attempt to maintain its leverage ratio, the financial institution must sell its assets, precisely at a time when their price is low. Thus, assuming that asset prices depend on the health of investors' balance sheet, erosion of investors' net worth further reduces asset prices, which feeds back into their balance sheet and so on. This is what Brunnermeier and Pedersen (2008) term as the "loss spiral". At the same time, lending standards and margins tighten, leading to the "margin spiral". Both these effects cause the borrowers to engage in a fire sale, lowering prices and deteriorating external financing conditions. Apart from the "balance sheet mechanism" described above, the lending channel can also dry up for reasons exogenous to the borrower's