Nobel Prize 2022: What is the role of banks in financial crises?
We sat down with our former director, Per Strömberg, a professor of finance at the Stockholm School of Economics and a member of the Nobel Prize Committee to discuss this year's economic sciences laureates. Their research has shaped the way we deal with financial crises, he says.
Our lives are closely intertwined with banks and financial systems. We get our salaries in our bank accounts, from where we make payments for our everyday essentials; with just the tap of a card, we get access to food, transport, and clothes. Banks are also involved in our lives during those big moments, like buying our first home or actualizing a business that we have dreamt of for years.
Yet, few can articulate what banks are, why they exist and why failures in the banking system can lead to disastrous crises that persist for a long time.
Ben Bernanke, Douglas Diamond and Philip Dybvig were awarded the Nobel Prize in Economics “for research on banks and financial crises”, which has improved how society deals with financial crises. The key finding in their research is why avoiding bank collapses is vital.
“They provide the foundation of what is now the modern understanding of banks: the role banks play in the economy, why we have financial crisis and why we need banks to be regulated,” Strömberg said.
“We think it's very important for economics, because it's made a huge impact on tons of research following their work, and also for practice, because a lot of modern thinking about regulation of the financial system, and how you fight financial crises, rests on their research,” he added.
Which came first, bank failure or depression?
Ben Bernanke wrote his winning paper in 1983, analyzing the Great Depression in the 1930s using empirical and historical data.
“(Bernanke) convinced the research community that the failure of banks and panic was really the reason why the Great Depression became so deep,” Strömberg said. “This was a huge break with the perceived wisdom at the time.”
Before Bernanke’s paper, the consensus among financial researchers about the bank failures in the 1930s was that they were a consequence of the depression.
Another view by economists Milton Friedman and Anna Schwartz, proposed that while the bank failures were important for the recession turning into a deep depression, it was primarily for monetary reasons, since bank deposits are part of money supply. They argued that the reason why the depression became longer and deeper than it should have been was because the Fed at the time did not print more money.
“They were very money-oriented,” Strömberg said. “Bernanke however, said that the bank failures were indeed important, not primarily because they shrank money supply but because when banks failed, firms and households couldn't get credit. And that had a huge effect on their performance and investment which fed into the economy, leading to a great depression.”
What are banks and why is it important they don’t fail?
Diamond and Dybvig meanwhile, developed a theoretical model explaining for the first time-- building from first principles-- the central mechanisms of banking: why it works, and how the system is inherently vulnerable and needs regulation.
Their model is based upon households saving some of their income, as well as needing to be able to withdraw their money when they wish. No one knows in advance if or when the need for money will arise, but this does not happen at the same time for every household. In the meantime, there are investment projects that need financing. These projects are profitable in the long-term, but if they are terminated early, the returns will be very low.
A liquidity problem arises in a world without banks. Households want to make sure that they have access to their funds whenever they want while borrowers need the assurance that they do not have to pay back their debt for at least a certain number of years.
“What Diamond and Dybvig’s model shows is that a bank, or an institution like a bank, solves this problem because as long as everyone is not going to need liquidity at the same time, you can pool all of these deposits, and use this money to lend to long term investment. That's what they mean by maturity transformation,” Strömberg said.
However, Diamond and Dybvig’s model also found that if depositors, for any reason, think that a bank might fail, they will rush to the bank to get their money, resulting in a self-fulfilling bank run.
“How do we avoid that outcome? Diamond and Dybvig showed that if we have deposit insurance, then we don't have to rush to the bank because we know we get our money back. Or if the central bank provides emergency loans to this bank, we know we will be safe,” Strömberg explained.
“Avoiding runs on financial institutions is what modern banking regulation is all about”.
Banks monitor borrowers but who monitors banks?
In a separate paper, Diamond analyzes how lenders ensure borrowers honor their commitments. He explained that it is easier and cheaper for depositors who have directly or indirectly invested in a project to delegate credit evaluation and investment progress monitoring to banks instead of doing it individually.
But if the bank is monitoring the borrowers to ensure their investments are sound, who is monitoring the banks? Diamond showed that the way in which banks are organized means they do not need to be monitored by the depositors at all.
“The reason we don't have to it is because banks lend to thousands of companies, not just one. If banks do their monitoring job correctly, the occasional firm might still fail but if you have lent to 10,000 different firms, it's predictable what those credit risks are given that the bank does its job,” Strömberg said.
“If the bank runs out of money, then we know that the bank hasn't done its job. We can then put that bank in bankruptcy and get our money back. We can discipline the bank without having to monitor it,” he said, adding that it is in the bank’s interest to monitor its borrowers without the depositors needing to monitor the bank.