Why do we need banks?

"The Nobel Memorial Prize in Economic Sciences was awarded on Monday to Ben S. Bernanke, the former Federal Reserve chair, and two other academics for research into banks and financial crises.

Douglas W. Diamond, an economist at the University of Chicago, and Philip H. Dybvig at Washington University in St. Louis won the prize alongside Mr. Bernanke, who is now at the Brookings Institution in Washington.

Mr. Bernanke in 1983 wrote a paper that broke ground in explaining that bank failures can propagate a financial crisis rather than simply being a result of the crisis.

Mr. Diamond and Mr. Dybvig the same year wrote a paper on the risks inherent in maturity transformation, the process of turning short-term borrowing into long-term lending. Mr. Diamond also wrote about how banks monitor their borrowers, noting that knowledge about borrowers disappears upon bank failures, extending the consequences of the upheaval.

“The laureates have provided a foundation for our modern understanding of why banks are needed, why they’re vulnerable, and what to do about it,” said John Hassler, an economist at the Institute for International Economic Studies at Stockholm University and a member of the prize committee.

Mr. Diamond spoke by phone at the news conference announcing the prize. Asked whether he had any warnings for banks and governments today, at a time when markets have been in turmoil as central banks around the world raise interest rates to fight rapid inflation, Mr. Diamond said that financial crises become worse when people begin to lose faith in the stability of the system.

“In periods when things happen unexpectedly — like, I think many people are surprised how rapidly nominal interest rates have gone up around the world — that can be something that sets off fears in the system,” he said. “The best advice is to be prepared, for making sure that your part of the banking sector is both perceived to be healthy, and to stay healthy, and respond in a measured and transparent way to changes in monetary policy.”

But he added that the world is better prepared for any financial upheaval now than it was during the financial crisis in 2008, because “recent memories of that crisis” and regulatory improvements have made the banking system less vulnerable. He noted, however, that the vulnerabilities that he and Mr. Dybvig have identified extend beyond banks, and can bubble up in other parts of the financial system, like insurance firms or mutual funds.

The economics award, among the highest honors in the field, is not, technically, a Nobel Prize. It is called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel because it wasn’t among the original categories that Alfred Nobel set out in his will in 1895. It is funded by Sweden’s central bank and has been given out only since 1969, though the Nobel committee promotes it and lists it on its website.

Ben S. Bernanke, the former chair of the Federal Reserve, on Monday won a Nobel Memorial Prize in economics for his research into banks and financial crises — work he was able to draw on in real time while fighting the worst downturn America had faced since the Great Depression.

Mr. Bernanke became Fed chair in 2006, shortly before U.S. house prices ended their breakneck ascent and began an unexpected and devastating decline. As the housing market cooled, overextended borrowers fell behind and defaulted on their mortgages, and a pile of risky mortgage debt that had been sliced, diced and parceled out across big banks and the broader financial system began to drag down institutions and break the gears of finance.

Mr. Bernanke, who received a Ph.D. in economics from the Massachusetts Institute of Technology and who taught at Princeton University before coming to the Fed as a governor in 2002, drew upon his research about the Great Depression to try to stem the fallout. He worked with colleagues to set up emergency programs that backstopped various markets on the brink of collapse, from short-term business debt to securitized loans. And alongside the Treasury Department, he used the Fed’s powers to enable bailouts for bank and insurance company portfolios.

Mr. Bernanke’s track record on the crisis included controversy. The Fed and Treasury Department allowed Lehman Brothers to fail, which Mr. Bernanke has said he and his colleagues believed was their only option. Some critics have since argued that the investment bank could and should have been saved. The ripple effects of that failure worsened the downturn, which lasted from 2007 to 2009 in the United States and sent activity tumbling around the world.

But the Fed acted aggressively to try to resuscitate the economy. Under Mr. Bernanke’s watch, it began to implement bond-buying policies in which it purchased huge amounts of government-backed debt to lower long-term interest rates. It also pushed toward greater transparency, beginning to hold quarterly news conferences (which now accompany every rate-setting meeting) and formally adopting an inflation target of 2 percent.

Mr. Bernanke left the Fed in 2014 and he is now a distinguished senior fellow at the Brookings Institution in Washington. He won the Nobel for his work on financial crises, including a 1983 paper that broke ground in explaining that bank failures propagate downturns and aren’t simply a side effect of them.

Diamond and Dybvig created an influential model about the dynamics of bank runs.

Douglas W. Diamond and Philip Dybvig have had enormously successful academic careers studying how things can go wrong with banks, and much of their work stems from a highly influential paper they wrote nearly 40 years ago, early in their careers.

The paper showed how banks create liquidity in the economy, and how this liquidity subjects banks to sudden, panicked withdrawals by customers if there is no deposit insurance or other protection.

It is “one of the most widely cited papers in finance and economics,” the University of Washington at St. Louis, where Mr. Dybvig is an economics professor, wrote in a statement.

The two economists developed the Diamond-Dybvig model showing that deposits used to finance business loans may be unstable and give rise to bank runs. Banks may need a government safety net, like deposit insurance, more than borrowers do.

This topic — how banks work, and how they can slip up, causing broad problems — continues to be relevant. In a video posted in 2019 by the Center for Economic Policy Research, Mr. Diamond described how, just before the financial crisis, there was a drastic increase in the number of loans that did not include covenants to help ensure the money would be paid back.

Researchers, he said, were looking into “why, in a boom period, just before the crisis,” was there so little incentive to be careful.

Mr. Diamond, who was born in 1953, has taught at the University of Chicago since 1979. “His research agenda for the past 40 years has been to explain what banks do, why they do it and the consequences of these arrangements,” the university said in a statement.

As an undergraduate he attended Brown University, earning a bachelor’s degree in economics, followed by master’s and doctorate degrees in economics at Yale.

He continues to teach at Chicago’s Booth School of Business, including a graduate course in corporate finance. He has previously taught as a visiting professor at the M.I.T. Sloan School of Management, the Hong Kong University of Science and the University of Bonn.

Before arriving at Washington University, Philip H. Dybvig, 67, taught at Yale and Princeton. He has published two textbooks.

Mr. Dybvig was raised in Dayton, Ohio, and attended Indiana University, earning a bachelor’s degree in math and physics. He later received a doctorate in economics at Yale, where he became a tenured professor.

“I have always worked on a wide range of topics,” he says on his university bio page. “My recent work includes work on the anti-corruption campaign in China, preservation of capital for educational endowments, and predictability of stock returns.”"

 

The financial crisis has shown that the order advocated by these Nobel laureates is detrimental to society. Banks collect profits for the riskiness of loans, and when those loans are not repaid, we, the voters, cover the losses. The state must nationalize all the assets of the rescued banks.