A Nobel for Insights About Banks and Financial Crises: Bernanke, Diamond, and Dybvig

As time goes by, I find it increasingly hard to explain to the non-econ world just what happened back in September 2008, when during a period of perhaps 2-3 weeks there seemed to me a meaningful chance (and by “meaningful,” I mean large enough to keep me awake at night) that the US banking and financial sector would melt down in a way that would have led not just to the substantial recession that did occur, but to something much worse.

But in one of those odd quirks of history, the Federal Reserve at that time was being chaired by a former academic economist named Ben Bernanke who was actually a recognized expert in the subject of banking and financial collapses, based on research that he and others like Douglas Diamond and Philip Dybvig had done back in the 1980s and 1990s. The Great Recession from 2007-2009 was very bad, and it could have been so much worse.

The Royal Swedish Academy of Sciences has now awarded what is formally known as the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022” to Bernanke, Diamond, and Dybvig “for research on banks and financial crises.” As usual, the prize committee has published two explanatory pieces for those who want to know what the fuss is all about. There’s a shorter “popular science background” article called “The laureates explained the central role of banks in financial crises,” and a longer and more technical (that is, about 70 pages) “scientific background article titled “Financial Intermediation and the Economy.” Earlier narratives tended to describe the “Great” character of the Depression as a list of poor decisions and things that went wrong. Bernanke made a strong case that the length and depth of the Great Depression was intimately tied to one main cause: the crisis fo the banking system at the time. The prize committee writes:

Prior to Bernanke’s study, the general perception was that the banking crisis was a consequence of a declining economy, rather than a cause of it. Instead, Bernanke established that bank collapses were decisive for the recession developing into deep and prolonged depression. Once a bank goes bankrupt, the relationship between the bank and its borrowers is cut; this relationship contains knowledge capital that is necessary for the bank to manage its lending efficiently. The bank knows its borrowers, it has detailed information about what borrowers have used the money for and what requirements are needed to ensure the loan will be repaid. Building up such knowledge capital takes a long while, and it cannot simply be transferred to other lenders when a bank fails. Repairing a failed banking system can therefore take many years, during which time the economy functions very poorly. Bernanke demonstrated that the economy did not start to recover until the state finally implemented powerful measures to prevent additional bank panics.

At about the same time in the early 1980s, Diamond and Dybvig were developing a theoretical model of banking and the financial sector that addressed these issues. They began with the basic idea of a bank as a “financial intermediary”–that is, some economic agents (people and firms) have savings they would prefer not to spend in the present, while others would like to borrow and spend now, and then repay later. Banks serve as the intermediaries between these groups.

But an immediate challenge arises here. What is a substantial number of savers been decide to withdraw their money from these theoretical banks, perhaps because the savers don’t trust that their savings are safe at the bank? The theoretical bank will not have the money for everyone: after all, that money has already been loaned out to people who borrowed to purchase homes and cars, and to businesses who borrowed to make investments. Thus, there is a possibility of a “bank run,” where people rush to the theoretical bank and try to withdraw their funds right now–and in doing so, they make it impossible for the bank to continue functioning.

The bank run is of course a staple of stories and accounts of the time before the 1930s: two of the best-known examples from movies are from Jimmy Stewart in It’s a Wonderful Life and when the little boy Michael tries to withdraw his tuppence from the bank run by Dick van Dyke in Mary Poppins. However, if the government provides deposit insurance, then there is no reason for bank runs. From this perspective, it isn’t a coincidence that when federal bank deposit insurance was enacted in 1933, he role of the fragile banking system in propagating the Depression faded away, and the worst of the Great Depression ended.

But a follow-up tradeoff emerges here. If there is bank deposit insurance, then savers no longer need to worry about whether the bank is making sensible decisions about lending, or whether the bankers are chasing higher risks and perhaps higher payoffs. Thus, Diamond in particular emphasized that deposit insurance needs to be paired with government oversight of banks to make sure that they are not taking undue risks. This pairing of deposit insurance and financial oversight of banks functioned to keep the US banking and financial system stable for a number of decades.

But there were warning signs that not all the problems has been addressed. Perhaps most notably, during the savings and loan crisis of the later 1980s, a number of S&Ls found themselves in a bad financial situation: they had made long-term loans for home mortgages over the previous decades at relatively low interest rates, but the high rates of inflation in the 1970s had pushed up interest rates. Under law, the S&Ls were limited in the interest rates they could pay, so savers instead wanted to move their funds to money market accounts, which didn’t have the same restrictions. This was a modern kind of bank run: funds being withdrawn from one part of the financial sector and moved to another. A number of the S&Ls were faced with bankruptcy as their deposits diminished, and some of the managers chose the strategy of making risky loans at high interest rates to try to regain solvency. Some politicians pressured the financial regulators of their local financial institutions not to crack down. Ultimately, federal government ended up needing to pay off more than $150 billion to protect depositors who had kept funds in these institutions. For more background, readers could start with the three-paper symposium in the Fall 1989 issue of Journal of Economic Perspectives.

With the Great Recession of 2007-9, a somewhat similar problem arose again. A substantial and growing part of the US financial sector had moved outside banks, into what is often called the “shadow banking” sector. If you wanted a loan for a house, you could get it through a non-bank institution, and behind the scenes, mortgage loans were repackaged and sold to investors like pension funds or insurance companies. Businesses found other ways to borrow as well, by using bond markets as well as their own versions of loans that were repackaged and resold. These shadow banking financial institutions were not under the rules of federal deposit insurance or the prudential scrutiny of federal bank regulators. Risky loans were made. And when the shadow banking institutions went sideways, the actual banking system was threatened as well. It was extraordinarily important to have a knowledge base, and people in charge who understood that knowledge base, to recognize that the dire problems of financial institutions in 2007 and 2008 should not just be viewed as an outcome of mortgage sector problems, but that these issues could become a cause of additional and deeper problems.

These underlying problems persist today. Every new innovation in the broader financial sector–the shadow-banking sector–raises the issue of possible financial runs from one sector to another, along with questions of how government might create (or not!) some combination of safety guarantees and a regulatory apparatus. The Nobel prize committee wrote:

Banks and bank-like institutions have existed for thousands of years. Today they are active in every country around the world. Banks obviously perform important functions, but they have also been at the epicenter of some of history’s most devastating economic crises such as the Great Depression. Nevertheless, it was not until the work of this year’s laureates, Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig, that we had a comprehensive theory of why banks exist in the form we observe, what role they play in the economy, why they are fragile, and an empirical account of how devastating and long-lasting the consequences of massive bank failures can be. …

The research from the 1980s for which this year’s Prize in Economic Sciences is awarded obviously does not provide us with final policy recommendations. Deposit insurance does not always work as intended. It can lead to perverse incentives for banks and their owners to gamble to take the profit if things go well and let taxpayers pay the bill if not. Runs on new financial intermediaries, engaging in profitable maturity transformation like banks, but operating outside of bank regulation, were arguably key for the financial crisis 2007–2009 leading to the Great Recession. When central banks act as lenders of last resort, this can lead to large and unintended wealth redistribution and have negative moral hazard
effects on banks who may increase reckless lending, potentially leading to future crises.

How to regulate the financial market so that it can perform its important function of channeling savings to productive investments, without from time to time causing financial crises, is a question that is actively debated to this day. The same is true about what policies are most effective in preventing a threatening crisis from developing. However, based on the foundational work of the laureates and all research that has followed, society is now better equipped to handle financial crises.