Ben Bernanke, Philip Dybvig and Douglas Diamond, recipients of the 2022 economics Nobel Prize.Credit: The Brookings Institution, Washington University, University of Chicago Booth School of Business
Three economists have shared the 2022 economics Nobel Prize 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, each shared equal parts of the 10 million Swedish kronor (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 both helped to explain why banks exist in the form they do, and why they have fragilities that can be devastating to the economy, as shown both in the Wall Street Crash of 1929 and the Great Depression that followed, and the global financial crisis of 2008. Insights from their work were essential to enabling banks, governments and international institutions to navigate the Covid-19 pandemic without catastrophic economic consequences, the Nobel committee said at its 10 October announcement.
Taming chaos
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 dynamical system with sensitive feedbacks that can send it spiralling out of control — for example, when panic among savers becomes self-amplifying and leads to a bank run that stops a bank from 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 all three laureates 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, 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 savers don’t in general need to withdraw all at the same time, banks can absorb the fluctuations to maintain ‘liquidity’, enabling money to circulate and society to benefit.
The model also showed the weakness of this system. If enough savers are hit by some external ‘liquidity shock’ — a societal event that makes them want to withdraw their money — this can lead to panic and a vicious circle, in which ever more of them withdraw in fear that the bank will run out of funds. This is an inherent instability that can lead to bank collapse, 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 is consistent with what happened in the 1930s2. Whereas previously it had been unclear if bank failures were a cause or consequence of the 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, the largest economic crisis in modern history. A bank crash leads to 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 2008 crash. It began with a slump in the housing sector, but led to panic in the financial markets, as the model of Diamond and Dybvig predicts. The panic triggered the collapse of financial-services companies such as the US-based Lehman Brothers, creating 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 reckless lending by banks 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. The crash highlighted the need for regulation of banking to avoid this behaviour. In the United States, that took the form of the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) in July 2010, while similar protections were implemented in the European Union and elsewhere. Diamond says, however, that while 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.”
Their 1983 paper “is the bedrock of thinking about financial crises”, says economist Kinda Hachem of the University of Virginia in Charlottesville. “Every discussion of whether financial regulation can eliminate crises leads back to this seminal work.”
Such lessons helped 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. We are now much better prepared for future crises, says Diamond. “Recent memories of [the 2008] 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 banks.
Bernanke’s awareness that factors outside of traditional 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 2008 crisis, says Jean-Philippe Bouchard, chairman 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 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.”