Three economists have shared the 2022 Nobel prize in economics for their pivotal theory of how banks work and how they fail.
Ben Bernanke at the Brookings Institution in Washington DC, Douglas Diamond at the University of Chicago in Illinois and Philip Dybvig at Washington University in St. Louis, Missouri, shared equal parts of the 10-million-Swedish-krona (US$915,000) award, formally known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
The research of the three laureates has helped to explain both why banks exist in the form they do and why they have fragilities that can be devastating to the economy, as shown in the Wall Street crash of 1929 and the Great Depression that followed, and in the global financial crisis of 2007–09. Insights from their work were essential in enabling banks, governments and international institutions to cope with the COVID-19 pandemic without catastrophic economic consequences, the Nobel committee said in its 10 October announcement.
Although the prize citation did not couch it in these terms, the laureates’ mathematical models and historical analyses reveal the banking system to be a nonlinear dynamic system with sensitive feedback mechanisms that can send it spiralling out of control. For example, panic among savers can become self-amplifying and lead to a run on banks that stops them providing loans to borrowers. The research helped to show how better regulation can reduce the risks, and how state intervention can restore stability — albeit at considerable cost to the taxpayer.
Before the key work of the three laureates, there was no general understanding of how banks play their role in society. In 1983, Diamond and Dybvig presented a mathematical model showing that banks act as intermediaries between savers and borrowers, smoothing out the incompatibility of their requirements1. Savers want to be able to invest and withdraw on a short-term basis, but borrowers such as businesses need long-term loans and commitments. Because in general not all savers need to withdraw at the same time, banks can absorb the fluctuations to maintain ‘liquidity’, thus enabling money to circulate, with benefits to society.
The model also showed the weakness of this system. If enough savers are hit by an external ‘liquidity shock’ — a societal event that makes them want to withdraw their money — this can lead to panic, and create a vicious circle in which ever more of them withdraw their funds in fear that the bank will run out. This is an inherent instability that can lead to the collapse of banks, although safeguards such as deposit insurance can reduce the risk. “Financial crises become worse when people start to lose faith in the stability of the system,” says Diamond.
“Diamond and Dybvig explained how a liquidity problem can arise through a self-fulfilling run on the bank,” says economist Atif Mian at Princeton University in New Jersey. “The simplicity of their mathematical argument is a thing of beauty, and the work has important policy implications.”
Cause and effect
Also in 1983, Bernanke showed that this picture of the function of banks is consistent with what happened in the 1930s2. Whereas previously it had been unclear whether bank failures were a cause or a consequence of the financial crisis, Bernanke showed that the crash was mostly driven by them. He also explained why, in this case, it led to a long-lived depression that became the largest economic crisis in modern history. The failure of a bank results in a loss of crucial information that banks acquire (and can pass on to others) on savers and borrowers. Without such assurances about the credit-worthiness of businesses and households, liquidity cannot be quickly re-established.
These insights shed light on the 2007–09 crash. It began with a slump in the housing sector, but led to panic in the financial markets, as Diamond and Dybvig’s model predicts. This triggered the collapse of financial-services companies such as Lehman Brothers, based in New York City, and created a global economic downturn. At the time, Bernanke was chair of the US Federal Reserve, which, along with the US Treasury, intervened as an emergency lender to preserve some liquidity and keep commercial banks from collapse. Similar interventions happened globally.
That crisis was widely considered to have been triggered by banks lending recklessly to borrowers in the housing market who lacked the means to repay their debts. The work of Diamond and Dybvig had already shown how perverse incentives can arise in the banking system to drive such risky lending strategies, and the crash highlighted the need for regulation to prevent this from happening. In the United States, that regulation took the form of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July 2010, and similar protections were implemented in the European Union and elsewhere. Diamond says that although it might be possible to set up the financial system to avoid financial crises, his work with Dybvig shows that “that’s probably not the best thing to do, because it is very difficult to have the creation of extra liquidity that the financial sector [needs] combined with universal financial stability”.
Diamond and Dybvig’s 1983 paper “is the bedrock of thinking about financial crises”, says economist Kinda Hachem at the University of Virginia in Charlottesville. “Every discussion of whether financial regulation can eliminate crises leads back to this seminal work.”
Such lessons helped to reduce the danger of illiquidity during the lockdowns of the COVID-19 pandemic. For example, the European Central Bank intervened with financial assistance to banks, and incentives for them to lend to consumers and businesses. The world is now much better prepared for future crises, says Diamond. “Recent memories of [the 2007–09] crisis and improvements in regulatory policies around the world have left the system much less vulnerable, and the banking sector is in solid shape, with good risk management.” But he warns that the vulnerabilities causing bank runs “can show up anywhere in the financial sector” — not just in banks.
Bernanke’s awareness that factors outside of conventional economic thinking — such as behavioural biases, feedback loops and the role of confidence collapse — can create instabilities in the system were probably critical for navigating the 2007–09 crisis, says Jean-Philippe Bouchaud, chair of Capital Fund Management (CFM) in Paris and co-director of the CFM–Imperial Institute of Quantitative Finance at Imperial College London. “When the crisis hit, I am quite certain he immediately understood what was going on, thanks to his deep knowledge of the 1929 crisis,” he says. “I feel that we were collectively lucky to have him at the helm of the Fed at the time, and I think (and hope) he will inspire more work on nonlinear and non-equilibrium effects in economic systems.”