Three economists have shared the 2022 Nobel prize in economics for their important theories about 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 the University of Washington in St. Louis, Missouri, shared an equal share of the 10-million-Swedish-krona (US$915,000) award, officially known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
The research of all three winners has helped explain both why banks exist in the form they do and why they have weaknesses that can destroy economies, as demonstrated in the Wall Street crash of 1929 and the Great Depression that followed, and in the global financial crisis 2007–09. Insights from their work are important in enabling banks, governments and international institutions to face the COVID-19 pandemic without major economic consequences, the Nobel committee said in its announcement on October 10.
Tame the chaos
Although the prize quote does not describe it in these terms, the winner’s mathematical model and historical analysis reveal the banking system as a nonlinear dynamic system with sensitive feedback mechanisms that can cause it to spiral out of control. For example, panic among savers can reinforce itself and lead to efforts by banks to prevent them from lending to borrowers. The research helps to show how better regulation can reduce risk, and how government intervention can restore stability — albeit at great cost to taxpayers.
Before the main work of the three winners, 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 needs.1. Savers want to be able to invest and withdraw in the short term, but borrowers like businesses need long-term loans and commitments. Because generally not all depositors need to withdraw at the same time, banks can absorb fluctuations to maintain ‘liquidity’, thus allowing money to circulate, benefiting society.
The model also shows the weaknesses 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 cause panic, and create a vicious circle in which more of them withdraw their funds for fear of running out of money. It is this inherent instability that can lead to bank collapse, although protections such as deposit insurance can reduce the risk. “The financial crisis got worse when people started to lose faith in the stability of the system,” Diamond said.
“Diamond and Dybvig explain how liquidity problems can arise through self-fulfillment in banks,” said economist Atif Mian at Princeton University in New Jersey. “The simplicity of their mathematical argument is beautiful, and the work has important policy implications.”
Cause and effect
Also in 1983, Bernanke pointed out that this picture of bank function was consistent with what happened in the 1930s.2. Although it was previously unclear whether bank failures were the cause or effect of the financial crisis, Bernanke indicated that the crash was mostly driven by them. He also explains why, in this case, it led to a prolonged depression that became the greatest economic crisis in modern history. A bank failure results in the loss of important information that the bank obtains (and can pass on to others) on depositors and borrowers. Without such assurances about the creditworthiness of businesses and households, liquidity cannot be quickly re-established.
These insights shed light on the 2007–09 crash. It started with a downturn in the housing sector, but led to a panic in the financial markets, as predicted by the Diamond and Dybvig model. This triggered the collapse of financial services companies such as Lehman Brothers, based in New York City, and created a global economic depression. At the time, Bernanke was chairman of the US Federal Reserve, which, along with the US Treasury, intervened as an emergency lender to maintain some liquidity and keep commercial banks from collapsing. Similar interventions are happening all over the world.
The crisis is widely thought to have been triggered by banks recklessly lending to borrowers in the housing market who had no means of repaying their debts. Diamond and Dybvig’s work has shown how perverse incentives can arise in the banking system to drive such risky lending strategies, and the crash highlights 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 of July 2010, and similar protections have been implemented in the European Union and elsewhere. Diamond says that while it is possible to set up the financial system to avoid a financial crisis, his work with Dybvig shows that “that is probably not the best thing to do, because it is very difficult to create the additional liquidity that the sector [needs] combined with universal financial stability”.
Diamond and Dybvig’s 1983 paper “was the foundation of thinking about the financial crisis”, says economist Kinda Hachem at the University of Virginia in Charlottesville. “Every discussion of whether financial regulation can eliminate the crisis leads back to this important work.”
Such lessons help mitigate liquidity risks during the COVID-19 pandemic shutdown. For example, the European Central Bank intervenes with financial aid to banks, and incentives for them to lend to consumers and businesses. The world is now better prepared for future crises, Diamond said. “Recent memories of [the 2007–09] The crisis and improvements in regulatory policies around the world have made the system less vulnerable, and the banking sector is in a strong state, with good risk management.” But he warned that vulnerabilities that cause banks to run “could appear anywhere in the financial sector” – not just in banks.
Bernanke’s awareness that factors outside of conventional economic thinking — such as behavioral biases, feedback loops and the role of confidence collapse — can create instability in the system may have been crucial to navigating the 2007–09 crisis, said Jean-Philippe Bouchaud, chairman 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’m sure he immediately understood what was happening, thanks to his deep knowledge of the 1929 crisis,” he said. “I think we were collectively lucky to have him at the helm of the Fed at that time, and I think (and hope) he will inspire more work on non-linear and non-equilibrium effects in the economic system.”