This year, the Nobel Prize for Economics has been awarded to three US-based economists for their research on banks and financial crisis. The award has been shared by Ben S Bernanke, Douglas W Diamond and Philip H Dybvig for significantly improving “our understanding of the role of banks in the economy, particularly during financial crises,”.
Their research has helped decode why banks exists in their current form and what are the vulnerabilities associated with it. While announcing the Nobel Prize, the committee said that insights from the works of the three laureates’ were essential to enabling banks, governments, and international institutions to navigate the Covid-19 pandemic without catastrophic economic consequences.
Diamond Douglas is an Associate Professor of Finance at the University of Chicago Booth School of Business. Philip Dybvig is Professor of Banking and Finance at the University of St. Louis, Olin Business School of Washington. Dr. Ben S. Bernanke is a distinguished senior fellow with the Economic Studies program at the Brookings Institution.
Diamond is considered as the founder of modern banking theory. He is known for his research into financial intermediaries, financial crisis and liquidity. One of Diamond’s most influential works was the Diamond-Dybvig model, which he co-developed with Dybvig in “Bank Runs, Deposit Insurance, and Liquidity” in the Journal of Political Economy in 1983. The Diamond-Dybvig model mentions that banks are repositories for consumers’ cash, but when banks make investments with that cash, it tends to tie up money so that it can’t be immediately liquidated. In normal times, this is a good way to create wealth, but it can lead to a crisis if everyone panics and tries to withdraw all their funds at the same time. To keep this from happening, it’s important to maintain government regulation and safety nets, such as providing deposit insurance, the theory says. The Diamond-Dybvig model has since been used to understand other run-like phenomena in markets during financial crises.
Bernanke, who’s now at the Brookings Institution, was recognized for his research on the role of bank failures in deepening and prolonging the Great Depression in the 1930s. Dr Bernanke’s research showed how bank runs had prolonged the Great Depression in the 1930s. He later applied some of those lessons during his time at the US Federal Reserve, which he led from 2006-2014. When the financial crisis hit, he pushed the Federal Reserve to intervene aggressively, slashing interest rates and helping to organise bailouts of some of America’s biggest banks – moves that were politically controversial. When Mr Bernanke published his work in 1983, bank failures were viewed as a consequence of economic crisis, rather than the cause.
Banks help to foster a more productive economy by channeling excess cash from depositors to borrowers in need of money to build homes and factories and businesses. Trouble can arise when depositors want ready access to their cash on short notice, but the money is tied up in long-term assets or investments. “If a rumor starts that people are going to take out their money from the bank, then everyone has an incentive to rush to the bank to take out money in time and not come last in line,” John Hassler of the Royal Swedish Academy of Sciences explained in announcing the prize. “This can create failing banks.” Savers want to invest and withdraw on a short-term basis, but borrowers need long-term loans and commitments. Since 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.
