Banks, finance and the 2022 Economics Nobel Prize

This year the Nobel Prize in Economics was awarded to Ben Bernanke, Douglas Diamond and Philip Dybvig for their work on the role of banks in the economy, particularly during financial crises. In this piece, Amartya Lahiri summarises their seminal works – Diamond and Dybvig on the essence of traditional banks, and Bernanke on the financial crisis during the Great Depression. He describes the Laureates’ impact on the understanding of modern-day financial crises, and their contribution to the field of economics.

This year’s Nobel Memorial Prize in Economics Sciences recognised the huge importance of banking and finance in modern macroeconomies. The winners – Ben Bernanke, Douglas Diamond and Philip Dybvig – pioneered two distinct but ultimately related themes of research on the role of banks in modern economies. Diamond and Dybvig co-authored a fundamental paper in 1983 on the logic underlying the existence of banks, and the inherent risk that it entails. Bernanke, working independently, published a seminal paper that same year on the role of banks in extending the Great Depression well beyond the initial contraction. In this post, I shall describe each of these works separately before bringing them together as part of the general theme outlined by the 2022 Economics Nobel committee.

Identifying the essence of banking and making it common sense

Diamond and Dybvig (1983) was perhaps the first paper that took on the task of articulating a clear reasoning for the socially useful existence of banks while also highlighting the potential risks underlying this role. Diamond and Dybvig based their analysis around two key observations. First, the gestation lag in productive investments is often long as projects take time to implement. Second, individual savers who finance these investments often have short term liquidity needs. These two features in the process of financial intermediation creates a problem because savers, worried about their liquidity needs, may be unwilling to have their funds tied-in long term.

Diamond and Dybvig’s insight was recognising that banks provide a potential solution to this intermediation problem. Since banks have many customers with different liquidity needs, banks could lend out the pooled deposits to long term borrowers and yet meet the withdrawal demands of individual depositors as long as banks knew the overall share of depositors who might have short-term liquidity needs. This ability to pool idiosyncratic liquidity shocks gave banks a special role in financing socially productive long-term investments that were illiquid in the short run.

Diamond and Dybvig noted that this banking structure was inherently fragile and prone to runs by depositors. Since banks at any point of time would only have a fraction of their total assets in short-term liquid assets, withdrawal demands by a large enough share of depositors would overwhelm the stock of liquid assets held by the bank. In such an event, the only way for the bank to meet withdrawal demands would be to prematurely liquidate some or all of their long-term assets. But this would, at best, recover only a fraction of the face value of these assets. Consequently, some depositors would lose their deposits. This fear of losing their deposits in the event of a run on the bank by other depositors creates a situation where the bank is always exposed to the possibility that depositors panic and run on the bank even when they have no short-term liquidity needs.

In this conceptualisation, banks facilitate socially productive long-term investments but are also inherently fragile and prone to runs due to a mismatch between the maturity structure of their assets and deposits. This parsimonious but trenchant structure also identified some simple policy interventions that could reduce or eliminate the possibility of costly bank runs. One such solution is the deposit insurance scheme which today is standard in most countries. Another was empowering an agency like a central bank to act as a lender of last resort.

The beauty of the Diamond-Dybvig paper is the simplicity of the framework, its identification of the essence of traditional banking and the mechanism underlying bank runs. Bank runs had been around for a long time, as had institutional innovations such as deposit insurance schemes. Diamond and Dybvig just cut through the whole set of confounding factors surrounding them with their identification of the essence of banking. Indeed, their basic perspective applies equally well to more contemporary intermediation through shadow banks. The test of a deep idea often is how obvious it seems once stated. The Diamond-Dybvig paper clears that bar by some margin. One would be hard-pressed to come up with a better illustration of the power of clear conceptual thinking in analysing issues and designing solutions.

Banks as aggregators of information on borrowers

While Diamond and Dybvig’s work addressed the mechanics underlying bank runs and how to deal with them, Bernanke’s Nobel winning work examined the macroeconomic consequences of bank runs and financial crises during the Great Depression of 1929-1938. A big puzzle amongst analysts of the Depression is about why it persisted for so long. Bernanke (1983) suggested that the disruptions caused by financial crisis during 1930-1933 were the reason for the persistence of the Depression.

Until Bernanke’s paper came along, the prevailing orthodoxy about the persistence of the Depression was the work of Friedman and Schwartz (1963). Friedman and Schwartz shared with Bernanke the conviction that the recurrent bank runs during 1930-1933 were the key triggers for the problem. However, their views diverged pretty starkly with regard to whether banks affect the economy through the asset side or the liability side of their balance sheets.

The standard view is the money view, wherein shocks to output and income reduce deposits with banks which, in turn, reduces money supply and loans. Friedman and Schwartz viewed the financial crisis around the Depression as impeding the recovery of the economy through this conventional money channel. Their diagnosis of the problem was that monetary policy at the time was not expansionary enough to offset this negative effect on bank liabilities.

Bernanke took issue with this view on the grounds that it was hard to find evidence for such long-lasting effects of monetary contractions. Instead, he proposed the idea, and provided supporting evidence, that banks play a crucial role in allocating credit in the economy by collecting and aggregating information about borrowers. This informational capital is crucial for alleviating the credit frictions caused by private information that otherwise limit the access to capital for many firms. The effect of the myriad bank runs during 1930-1933 was that a lot of this bank-specific informational capital was destroyed due to many bank closures. Consequently, credit availability contracted sharply and caused a prolonged propagation of the Great Depression.

This credit view of why banks matter was a fairly striking departure from the money view. To be fair, there was a precursor to Bernanke’s work in the writings of Minsky (1977) and Kindleberger (1978). Bernanke’s contribution was distinct in terms of the clarity of its writing, the sharpness of the tests and, unlike Minsky and Kindleberger, it didn’t deviate from the assumption of rational expectations. While rationality is not necessarily a feature that experimental economists find widespread support for, nevertheless, from a structural standpoint, it provides a discipline to models that prevents results from drifting dangerously close to the underlying assumptions.

The impact that Bernanke’s work had on the profession is probably testimony to its importance. It sparked a big literature on the credit channel of monetary policy with researchers proposing models and providing evidence on the role of bank finance. This work on the credit channel actually diverged into two branches. The first was the ‘traditional’ credit channel, which focused on the special role of banks. A second branch, often called the ‘balance sheet’ channel, examined the effect of monetary policy on the financial income and wealth of firms and individuals. This too was clearly distinct from the traditional money channel.¹

Understanding and fighting the 2008 financial contagion

The financial crisis of 2008 brought together the works of Bernanke, Diamond and Dybvig. The crisis had a clear flavor of the Diamond-Dybvig mechanics for banking panics. In the lead-up to the crisis there was a significant increase of repo holdings by cash-rich entities. These repos were mostly backed by mortgage-based debt securities. Panic about the worthiness of the underlying collateral and fears of being left holding worthless scraps of paper created a massive sell-off by holders of the repos. This led to a big segment of the market for secondary debt shutting down (these facts are concisely laid out in Gorton and Metrick (2012)).

The dynamics described above sound very much like the mechanics of a crisis in the Diamond-Dybvig model except for the fact that the asset-backed repos were being issued in the shadow banking sector rather than traditional banks. Hence, the panic was in the shadow banking sector rather than traditional banks.².

As it happened, the 2008 crisis occurred while Bernanke was helming the Federal Reserve Board of the United States (the Fed). Armed with his research-based perspective on the effect of the financial crisis and bank runs during the Depression, Bernanke shepherded the Fedtowards an aggressive policy of conventional and unconventional expansions of money and credit in the system. The goal was to prevent the crisis shutting down credit access for firms and businesses, as had happened in the 1930s. It should be pointed out that the aggressive monetary easing by the Fed under Bernanke was not without pushback as critics argued that the policies encouraged moral hazard in the system and prevented rapid adjustments through closures of non-profitable entities.

Concluding thoughts

The Nobel Prize is supposed to recognise a contribution that generated the “greatest benefit for mankind.” That is a high bar, with little clarity on how one measures such benefits. The issue becomes even tougher once we depart from the physical sciences to a field like economics. There is thus a temptation to convert the prize into a lifetime achievement award (though, to be fair, the committee always strives to link the award to one or two specific papers). This year’s award is a mix of recognising a particular research contribution and a particular researcher.

The award to Diamond and Dybvig is closest in spirit to the original intent of the prize: to recognise an outstanding contribution to the world of knowledge in the field. Their model was a pathbreaker that is essential reading across graduate programs worldwide, forms the basis of policy perspectives, and has stood the test of time– both in terms of its simple beauty and its insights. The award to Bernanke is more of a recognition of a lifetime of work on a common theme. His body of work has been influential for researchers and policymakers; he himself has been at the forefront of guiding policy during similar crises and using those insights for the betterment of society.

In summary, this year’s award was well chosen and well deserved.

Notes:

While there were many researchers that worked on these themes, a sampling of this research can be found in Bernanke and Blinder (1988), Bernanke and Gertler (1995), Bernanke, Gertler and Gilchrist (1996), Gertler and Gilchrist (1993) and Kashyap and Stein (1994), amongst others.
Interested readers should look up Gorton (2012) to see more clearly the link of the financial crisis to the Diamond-Dybvig model