Nobel Prize 2022: Of banks and crises
Dec 2022
Sveriges Riksbank Prize in Economic Sciences
It is almost impossible to predict when the next financial crisis will occur. However, we know how to react correctly in such a crisis. This year's Nobel Prize honors three economists for their research on banks and how their actions contribute to the formation of financial crises.
This article by Christian Ewerhart, Mathias Hoffmann, and Joachim Voth was originally published in German by Die Volkswirtschaft, 10 November 2022. Translated and edited for layout purposes by the UBS Center.
"Why didn't anyone see this coming?" asked the recently deceased Queen Elizabeth II at the height of the 2007-08 financial crisis. Like the Queen, many people see the task of economics as predicting the economic future. The 2022 Alfred Nobel Memorial Prize in Economics was awarded to U.S. researchers Ben Bernanke, Douglas Diamond, and Philip Dybvig for scientific work on the causes and consequences of financial crises. However, their work illustrates that simple mathematical models and a thorough analysis of the past can provide fundamental insights that are more relevant for economic policy decisions than for any attempt at hectic forecasting.
Banks as fire accelerators
Ben Bernanke's most important essay, published in 1983, deals with the Great Depression of the 1930's (Bernanke, 1983). The Great Depression, as it is also called, remains the greatest economic catastrophe in history. What began in October 1929 with a stock market crash initially looked like a normal economic downturn until 1931. This eventually led to the serial collapse of banks. In his essay, U.S. economist Bernanke explores the question of whether the collapse of the financial sector itself might not have been the main reason why a normal recession turned into the primordial economic catastrophe of the 20th century.
He was thus not the first to point to the role of the banking sector in the Great Depression. Economists Milton Friedman and Anna Schwartz had already argued in 1963 that the restrictive monetary policy of those years impaired the banks' ability to create credit and thus led to a recession (Friedman and Schwartz, 1963). For Friedman and Schwartz, however, banks were merely a cog in the transmission mechanism. For them, the decisive impulse came from the restrictive monetary policy of the Federal Reserve, the U.S. central bank, known as the “Fed”. Friedman and Schwartz claimed that bank failures were thus a symptom, not a driver, of the crisis.
Bernanke modestly presented his approach as a complement Friedman and Schwartz’s thesis but at the same time showed with razor-sharp precision that a restrictive monetary policy alone could not explain the extent and duration of the depression. Rather, the bank collapses themselves acted as an accelerant.
Negative spiral sets in
Bernanke draws attention to the role of banks in granting loans to households and firms. A realistic assessment of credit risks by the bank requires qualified personnel and the maintenance of long-term relationships with customers. This builds up a capital of trust that often makes the granting of loans economically viable for both sides. If a bank collapses, it is not only affects the bank's savers and owners, but also the loan customers, because the trust capital built up at "their" bank cannot be simply transferred to another bank. Customer advisors at the bankrupt bank are laid off, the often informal knowledge about the customers and their creditworthiness is lost, until the credit supply to the customers finally collapses. The bank failure is followed by a wave of bankruptcies among bank customers, and especially among small companies that are particularly dependent on banks for their credit supply.
But worse is yet to come. A self-reinforcing mechanism known as the "financial accelerator" is now in motion because it accelerates the spread of the crisis to the entire economy: bank failures reduce the supply of credit to the economy as a whole, and corporate failures lower the average creditworthiness of bank customers. Even healthy banks now lend less because it becomes increasingly difficult to assess their customers’ default risks correctly. At the same time, household and corporate insolvencies lead to loan defaults, which leads to new bank failures, and so on...
Banks are fragile - and that's the way it has to be
At first glance, the second idea honored by the Nobel Committee this year could not be more methodologically contradictory. If Bernanke's argument was empirical, the two U.S. economists Douglas Diamond and Philip Dybvig sketched out a convincing theoretical model in a 1983 paper in which banks can be either economically useless (but stable) or dangerously fragile (and economically useful) (Diamond and Dybvig, 1983). The danger of banking crises, which is readily regarded as a state of emergency, a management error, or even a moral problem, is thus at the core of banking and the entire financial sector.
The Diamond-Dybvig model explains with a few mathematical formulas the basic economic problem that banks solve: On the one hand, households want to be "liquid" - that is, able to withdraw their savings whenever they want. On the other hand, entrepreneurs need long-term loans for investment projects. In an economy without banks, households would have to invest their savings directly in long-term loans, but would thus no longer be liquid.
Banks solve this dilemma. They convert demand deposits with short maturities into loans with long maturities by holding only a small portion of the deposits as a liquidity reserve and lending the larger portion on a long-term basis. This is usually unproblematic, as usually only a few customers want to withdraw their demand deposits at the same time. In macroeconomic terms, this so-called maturity transformation is highly welcome, because it is the only way to finance highly productive but long-term investments. However, maturity transformation also makes banks inherently unstable.
Dangerous mass panic
This instability exists because if doubts now arise about the bank's creditworthiness, many customers will suddenly try to withdraw their savings. If the bank's liquidity reserves are not sufficient to satisfy all depositors at the same time, such a "bank run" can lead to the collapse of the bank. This not "only” affects the bank’s depositors and owners , but its borrowers as well. They lose their source of financing for new projects - an important reference to the work of Bernanke, who referred precisely to such a credit crunch.
Incidentally, a bank run can occur even if the bank is rock solid and all doubts about its creditworthiness are unfounded. This is precisely what makes it so difficult to predict a run. True, there are indicators that make a crisis more or less likely. However, the exact "when" and "how" of a financial crisis is almost impossible to predict! In this respect, Diamond and Dybvig also provide an answer to the Queen's question here.
In another influential 1984 article, Diamond (this time without Dybvig) analyzed the role of banks as controllers of borrowers (Diamond, 1984). If there were no banks, savers would have to invest directly in loans and monitor for themselves whether their money was being well managed. Diamond's model shows that banks reduce borrowers' financing costs by performing this important control function for savers. This is efficient, but it also means that when banks fail, this control function can no longer be properly performed. The intermediation of liquid savings into economically productive investments comes to a standstill - with the consequences Bernanke pointed out.
Insights more relevant than ever today
The work of the three prize winners is the intellectual foundation on which both banking regulation and economic policy instruments to contain financial crises are built today. The solutions proposed by Diamond and Dybvig are still highly topical after 40 years. In the European monetary union, for example, common deposit insurance is now under consideration to avoid runs on individual national banking systems. And central banks are hesitant to introduce central bank accounts for private customers, partly because of fears of a "digital run" (see box).
During his time as Fed chairman from 2006 to 2014, Bernanke himself proved the usefulness of his own research findings. Under his aegis, the Federal Reserve bailed out numerous banks from 2008 to 2010 - not because it was morally right, but to avoid a repeat of the Great Depression of 1930. That was certainly controversial in 2008. To set an example, Lehman Brothers was allowed to go bankrupt before it changed its mind.
Queen Elizabeth II can no longer hear the answer. But the insights of the economists honored with this year's Nobel Prize have proved quite helpful, especially during the major financial crises of the last 20 years.
It is almost impossible to predict when the next financial crisis will occur. However, we know how to react correctly in such a crisis. This year's Nobel Prize honors three economists for their research on banks and how their actions contribute to the formation of financial crises.
This article by Christian Ewerhart, Mathias Hoffmann, and Joachim Voth was originally published in German by Die Volkswirtschaft, 10 November 2022. Translated and edited for layout purposes by the UBS Center.
"Why didn't anyone see this coming?" asked the recently deceased Queen Elizabeth II at the height of the 2007-08 financial crisis. Like the Queen, many people see the task of economics as predicting the economic future. The 2022 Alfred Nobel Memorial Prize in Economics was awarded to U.S. researchers Ben Bernanke, Douglas Diamond, and Philip Dybvig for scientific work on the causes and consequences of financial crises. However, their work illustrates that simple mathematical models and a thorough analysis of the past can provide fundamental insights that are more relevant for economic policy decisions than for any attempt at hectic forecasting.
About the mood image: This is not your average bank in real life. Gringotts is the only known bank of the Harry Potter wizarding world and it is operated primarily by goblins. Wizards and witches keep their money and other valuables in vaults that are protected by very complex and strong security measures. Photo: unsplash / Dan Cutler
Digital bank runs
Since the award-winning research was published, digital transformation has continuously changed our money and payment system. In particular, with the advent of cryptocurrencies, central bankers and academics have begun evaluating the possibilities of introducing a central bank digital currency ("CBDC"). This must be thought of as a type of electronic cash for retail customers. However, in addition to unanswered questions about data protection, there is also concern that a CBDC for private customers could dramatically increase the risk of a banking crisis. After all, central bank money would be a safe alternative to bank deposits at any time - regardless of deposit insurance. And since a transfer of complete demand deposits would be possible for a concerned bank customer with just a few mouse clicks, such a "digital run" could be much faster compared to a traditional bank run, potentially causing even more damage.
Since the award-winning research was published, digital transformation has continuously changed our money and payment system. In particular, with the advent of cryptocurrencies, central bankers and academics have begun evaluating the possibilities of introducing a central bank digital currency ("CBDC"). This must be thought of as a type of electronic cash for retail customers. However, in addition to unanswered questions about data protection, there is also concern that a CBDC for private customers could dramatically increase the risk of a banking crisis. After all, central bank money would be a safe alternative to bank deposits at any time - regardless of deposit insurance. And since a transfer of complete demand deposits would be possible for a concerned bank customer with just a few mouse clicks, such a "digital run" could be much faster compared to a traditional bank run, potentially causing even more damage.
Photo: unsplash / Dmitry Demidko
Bibliography
Bernanke, Ben S. (1983). Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, American Economic Review 73, 257–276.
Diamond, Douglas W. und Philip H. Dybvig (1983). Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy 91, 401–419.
Diamond, Douglas W. (1984). Financial Intermediation and Delegated Monitoring, Review of Economic Studies 51, 393–414.
Friedman, Milton und Anna J. Schwartz (1963). A Monetary History of the United States 1867–1960, Princeton University Press.
Nobel Prize videos
Contact
UBS Foundation Professor of Macroeconomics and Financial Markets
Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.
UBS Foundation Professor of Macroeconomics and Financial Markets
Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.