Nobel prize for banking and finance long overdue

The 2022 Riksbank Prize in Economic Sciences (the economics ‘Nobel’ prize was 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 contributions are to show the importance of the financial sector in deepening the Great Depression of 1929–1939 (Bernanke), lay the theoretical foundation for the role of banks in the economy and explain their fragility (Diamond and Dybvig). While the models of the 1980s might seem simplistic from today’s viewpoint, as we now possess much richer insights into credit cycles, systemic risk and the working of financial markets, still, it is the work of the three laureates that established this field of research.

Two-faced banking: growth and fragility

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 the underlying idea that banks turn depositors’ savings into loans (rather than loans originating via the private money creation privilege banks hold), this does not take anything away from the insights of the model: one, banking is fragile; two, banks can help increase long-term investment and growth; and three, growth and fragility go hand-in-hand. It is the latter that has often been ignored. By being fragile, banks can support growth. One cannot get one without the other.

The model that keeps on giving

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 the real economy – that is, household and firms. This work in turn motivated and informed an extensive empirical research programme into the effect of financial sector development on economic growth, kicked off by King and Levine (1983). As important, the Diamond–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 the financial safety net and market discipline (for example, Diamond and Rajan 2001).

The Diamond–Dybvig model has become a workhorse model for financial economists. In a paper recently accepted for publication, my co-authors and I use an extension of this model to provide a theoretical foundation for why banks’ liquidity creation is associated with higher growth in tangible but not intangible assets. This ultimately shows the importance as well as the limitations of banks, and points to the need to strengthen other segments of the financial system.

Why bank failures matter

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 fallout of the Great Recession). He makes a clear case that the financial sector is not simply a channel between the monetary and the real side of the economy (and bank failures a result of the depression) but that agency problems (information asymmetries and different interests) between banks and borrowers as well as banks and depositors have a real impact on the real economy. Ultimately, this motivated an expansion of research on banking crises and their real-economy repercussions, as well as the importance of bank–borrower relationships. A paper I co-authored on the failure of the Portuguese Banco Espirito Santo (2021) relates to this work.

The essential research–policy synergy

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, briefly) 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 2007–2008 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.

Outdated? No. Overdue? Yes.

There are the usual criticisms of 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 as the prize for Banerjee, Duflo and Kramer in 2019 for their work on randomised control trials, but all three 2022 laureates 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 when illiquidity in many debt markets led investors to try and sell government bonds and redeem from money market funds). Yesterday’s depositor runs are today’s market freezes. Finally, there is the criticism that banks do much more than intermediation – very true, but it does not make 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, who show that relaxing funding constraints on banks leads to banks lending more.

 

Thorsten Beck is Director of the Florence School of Banking and Finance and Professor of Financial Stability at the European University Institute. He is a research fellow of the Centre for Economic Policy Research (CEPR), London and the Center for Economic Studies (CESifo), Munich.

The original version of this post appeared on 11 October on the author’s blog site, thorstenbeck.com.