Finance: Research, Policy and Anecdotes

A Nobel Prize for banking and finance

The 2022 Riskbank Prize in Economic Sciences (the economics ‘Nobel’ prize is actually not among the original Nobel prizes, something that other social scientists like to remind economists of, every October) has been awarded to three economists researching financial intermediation and financial crises: Ben Bernanke, Doug Diamond and Philip Dybvig. Their main contribution: showing the importance of the financial sector in deepening the Great Depression (Bernanke) and laying the theoretical foundation for the role of banks in the economy and explaining their fragility (Diamond and Dybvig). And while the models of the 1980s might seem simplistic from today’s viewpoint and we have gained much richer insights into credit cycles, systemic risk and the working of financial markets, it is the work the three laureates that started this literature.   

 

The Diamond/Dybvig model has been the start of an expansive literature on bank runs, both informed (fundamental) and uninformed (irrational) ones.  While some might criticise it because the underlying idea that the depositors’ savings are intermediated into loans (rather than loans originated via the private money creation privilege banks hold) this does not take anything away from the insights of this model: one, banking is fragile; two, banks can help increase long-term investment and growth, and three, growth and fragility go hand-in-hand.  And it is the latter that has often been ignored – by being fragile, banks can support growth. One cannot get one without the other. The Diamond and Dybvig (1983) and Diamond (1984) papers were also part of an extensive theoretical literature providing a micro-foundation for the interaction of financial intermediaries and markets and real economy, a literature that ultimately motivated and informed the empirical finance and growth literature, kicked off by King Levine (1983) and to which I have made a small contribution as well. As important, the Diamond and Dybvig model also informed much subsequent work and discussion on the role of the financial safety net (including deposit insurance) and bank regulation, as well as the interaction between financial safety net and market discipline (e.g., Diamond and Rajan, 2001)

 

The Diamond/Dybvig model has become a workhorse model for financial economists. In a recent paper just accepted for publication, we also use an extension of this model to provide a theoretical foundation of why banks’ liquidity creation is associated with higher growth in tangible but not intangible assets.  This ultimately shows the importance but also limitations of banks and points to the importance of other segments of the financial system.

 

Ben Bernanke’s work has shown the negative impact of bank failures on the real economy and how bank failures exacerbated the Great Depression (and similarly the fall-out of the Great Recession). He makes a clear case that the financial sector is not simply a channel between monetary and real side of the economy (and bank failures a result of the depression) but that agency problems between banks and borrowers as well as banks and depositors have a real impact on the real economy. Ultimately, this motivated an expansive literature on banking crises and its real economy repercussions, but also the importance of bank-borrower relationships. Our paper on the failure of the Portuguese Banco Espirito Santo (2021) relates to Ben’s work.  One interesting dimension of this Nobel Prize is that one of the recipients, Ben Bernanke, is not only an eminent academic but was also a policy maker.  This has led to some rather embarrassing headlines (as in the New York Times), but also underlines that this type of research is critical for policy making.  Ultimately, Ben Bernanke happened to be Federal Reserve Chair right when the Global Financial Crisis brought about a somewhat similar situation as the Great Depression he had studied, something that did influence his (and other central bankers’) policy reaction.

 

There are the usual criticisms against this Nobel Prize – one is that it is outdated as it rewards work done 40 years ago. What is outdated for some is overdue for others! It is certainly not as close to current research work as the prize for Banerjee, Duflo and Kramer in 2019, but all three are still very active in research and policy debate. Another criticism is that depositor runs do not cause financial crises (or worse that Diamond/Dybvig’s theory is responsible for the Global Financial Crisis). Yes, runs might not cause crises, but they can certainly trigger them (as also seen during the Global Financial Crisis when wholesale markets froze or recently during the Dash for Cash episode in March 2020). Yesterday’s depositor runs are today’s market freezes. And finally, there is the criticism that banks do much more than intermediation – very true, but it does not turn the laureates’ insight obsolete.  And those who think that bank funding might not matter for bank lending, might want to consult this recent paper by my (former) colleagues Elena Carletti and Vasso Ioannidou and others.