Three economists shared the 2022 Nobel Prize in Economics for their fundamental theory of how banks work and fail.
Ben Bernanke of the Brookings Institution in Washington, DC, Douglas Diamond of the University of Chicago in Illinois, and Philip Dybvig of Washington University in St Louis, Missouri, each shared the $10 million prize equally. Swedish Krona (USD 915,000), officially known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
The research of the three laureates has both helped to explain why banks exist in the form they have and why they exhibit fragilities that can be devastating to the economy, as demonstrated by both the Wall Street crash of 1929 and the ensuing Great Depression, and the global financial crisis of 2008. The lessons learned from their work were essential to enable banks, governments and international institutions to navigate the Covid-19 pandemic without catastrophic economic consequences, the Nobel committee said in its Oct. 10 announcement.
Tame the chaos
Although the award citation did not phrase it in these terms, mathematical models and historical analyzes of the awardees reveal that the banking system is a nonlinear dynamic system with sensitive feedbacks that can cause it to explode – for example, when the panic among savers becomes amplified and leads to a bank run which prevents a bank from extending loans to borrowers. The research has shown how better regulation can reduce risk and how state intervention can restore stability, albeit at considerable cost to the taxpayer.
Prior to the key work of the three winners in 1983, there was no general understanding of how banks play their role in society. Diamond and Dyvbig presented a mathematical model showing that banks act as intermediaries between savers and borrowers, mitigating the incompatibility of their requirements1. Savers want to be able to invest and withdraw in the short term, but borrowers such as businesses need long-term loans and commitments. Because savers generally do not need to withdraw them all at once, banks can absorb fluctuations to maintain “liquidity,” allowing money to flow and society to benefit.
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 – it can lead to panic and a vicious cycle, in which more and more of them withdraw lest the bank run out of funds. This is an inherent instability that can lead to bank collapse, although safeguards such as deposit insurance can reduce risk. “Financial crises get worse when people start to lose faith in the stability of the system,” Diamond says.
“Diamond and Dybvig explained how a liquidity problem can arise during a self-fulfilling run on the bank,” says economist Atif Mian of 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 image is consistent with what happened in the 1930s2. While previously it was unclear whether bank failures were a cause or a consequence of the crisis, Bernanke showed that the crash was mainly due to them. He also explained why, in this case, it led to a long-lasting depression, the greatest economic crisis in modern history. A banking crash results in the loss of crucial information that banks acquire (and can pass on to others) about savers and borrowers. Without such assurances about the solvency of businesses and households, liquidity cannot be quickly restored.
This information shed light on the crash of 2008. It started with a crash in the housing sector, but led to panic in the financial markets, as predicted by the Diamond and Dybvig model. The panic triggered the collapse of financial services firms such as US-based Lehman Brothers, creating a global economic downturn. At the time, Bernanke was chairman of the US Federal Reserve, which, along with the US Treasury, stepped in as an emergency lender to preserve some liquidity and prevent commercial banks from collapsing. Similar interventions have occurred around the world.
This crisis was widely believed to have been triggered by reckless lending by banks to borrowers in the housing market who could not afford to repay their debts. Diamond and Dybvig’s work had already shown how perverse incentives can arise in the banking system to drive such risky lending strategies. The crash highlighted the need for banking regulation to prevent this behavior. In the United States, this took the form of the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) in July 2010, while similar protections have been put in place in the European Union and elsewhere. Diamond says, however, that while it may be possible to set up the financial system to avoid financial crises, his work with Dybvig shows that “it’s probably not the best thing to do, because it’s very difficult to ‘have the creation of additional liquidity’. that the financial sector [needs] combined with universal financial stability.
Their 1983 paper “is the foundation of thinking about financial crises,” says economist Kinda Hachem of the University of Virginia at Charlottesville. “Every discussion of whether financial regulation can eliminate crises brings us back to this seminal work.”
Such lessons have helped reduce the danger of illiquidity during the Covid-19 pandemic shutdowns. For example, the European Central Bank has stepped in with financial assistance to banks and incentives for them to lend to consumers and businesses. We are now much better prepared for future crises, says Diamond. “Recent memories of [the 2008] The crisis and improvements in regulatory policies around the world have made the system much less vulnerable, and the banking sector is healthy, with good risk management. But he warns that the vulnerabilities driving bank runs “can appear anywhere in the financial sector” – not just banks.
Bernanke’s realization that factors outside of traditional economic thought—such as behavioral biases, feedback loops, and the role of trust collapses—can create instabilities in the system was probably key to getting through the crisis of 2008, says Jean-Philippe Bouchard, president of Capital Fund Management 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 says. “I think we were collectively lucky to have him leading the Fed at the time, and I think (and hope) that he will inspire more work on nonlinear and non-equilibrium effects. in economic systems.