With the awarding of the Nobel Prize in Economics to Ben Bernanke, Douglas Diamond and Philip Dybvig, the jury is rewarding “fundamental research” on the role of banks in calm times but also in the turmoil of financial crises.
The works hailed on Monday date back to the 1980s: on the one hand, the work of the American duo Douglas Diamond and Philip Dybvig on the functioning of banks. On the other, former US Federal Reserve Chairman Ben Bernanke’s analysis of the Great Depression of the 1930s.
The “key” role of banks…
It was in 1983 that the “Diamond-Dybvig model” was born. The two researchers explain how banks work “but also why the system is vulnerable and needs to be regulated”, explains the Swedish Academy of Sciences, responsible for awarding the prize.
It is “one of the most cited scientific papers in economics and finance,” according to Washington University in St. Louis, where Mr. Dybvig teaches.
The model focuses on the role of banks as intermediaries: receiving deposits from savers and distributing loans to finance households but above all companies, thus enabling the economy to function.
These investments by banks in companies are a priori profitable in the long term and bring them income. Banks use the money entrusted to them by savers for this purpose, keeping only part of it accessible in case a few customers wish to withdraw their money.
Suddenly, if panicked, too many customers wish to withdraw their savings at the same time, this puts the banks in difficulty. Until causing a deep crisis affecting “even fundamentally healthy banks”. The system is “vulnerable to rumours”, summarizes the academy.
… in financial crises
Bernanke’s work on the Great Economic Depression of the 1930s “can be seen as supporting the ideas developed” by Diamond and Dybvig, the Nobel committee notes.
Mr. Bernanke detailed “the importance of (bank) credit in the spread of the depression” and demonstrated the impact of bank failures and the freezing of credit distribution, which aggravated the crisis.
Until then, the collapse of the banking system was mainly seen as a consequence, or at best, as a secondary cause of crises.
The work of the three winners “reinforces each other” and sheds light on how the vulnerabilities of banks, which are essential for the functioning of the economy, can lead to or even cause “devastating financial crises”, explains the jury.
Up-to-date lighting
According to the academy, the work of the three laureates has proven to be “extremely valuable” in analyzing the last two major crises: the 2008 financial crisis, after the bankruptcy of the American bank Lehman Brothers, and the Covid-19 pandemic.
Their work had shown the importance of good banking regulation as early as the 1980s. “Before the 2008 crisis, the sector was not perceived as particularly vulnerable in the world of finance and regulators,” Douglas Diamond said at a press conference on Monday.
At that time, the “panic in the financial markets had a dramatic effect on the real economy” by leading to a reduction in the supply of credit to households and businesses, explains the Nobel committee.
On the contrary, during the Covid-19 pandemic, central banks “made sure to maintain credit to households and businesses”, thus limiting the damage.
The three award-winning economists “taught us that these policies are crucial ingredients in avoiding episodes of bank runs and preserving credit relationships,” the committee adds.
The 2008 crisis “and the improvements in regulation have made the system much less vulnerable today,” assures Mr. Diamond, who also underlines the good financial shape of the banks.
The problem, he adds, “is that vulnerabilities, panic episodes, upheavals and other crises can happen anywhere in the financial sector, not just at the level of commercial banks”.