Published on 10 May 2023

Advancing the Understanding of the Role of Banks in the Economy, particularly during Financial Crises: 2022 Nobel Prize in Economic Sciences

Assistant Professor He Tai-Sen | School of Social Sciences (Division of Economics), NTU

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The 2022 Nobel Prize in Economic Sciences was awarded to American economists Dr Ben Bernanke (The Brookings Institution), Prof Douglas Diamond (University of Chicago), and Prof Philip Dybvig (Washington University in St. Louis) for their groundbreaking contributions to better understanding the role of banks in the economy, particularly during financial crises.

The economists’ collective research on banks and financial crises was conducted almost forty years ago in the early 1980s and has helped answer important questions about banks. Specifically, Profs Douglas Diamond and Philip Dybvig developed theoretical models to explain why banks exist, why they are vulnerable to rumors of collapse, and how regulation can reduce bank runs. Dr Ben Bernanke made empirical contributions on how banks could worsen the economy when economic conditions are already poor.

Why do banks exist?

Here, banks refer to commercial banks whose major operations focus on taking deposits and making loans. When taking deposits from savers, banks understand that most savers will not need their savings at any given time and can thus invest the savings in assets (e.g. loans) that are less liquid than cash but pay higher returns. That difference in liquidity then allows banks to pay interest to savers. This business model has another advantage as well: since banks make loans to a diversified pool of borrowers, having all borrowers fail to repay their loads all at once is an unlikely occurrence, insuring banks against default risk. The laureates’ collective work explains why the lending and deposit-taking by banks can naturally co-exist.

Why are banks vulnerable to rumors of collapse?

The nature of banking operations makes banks vulnerable to rumors of collapse, for a simple reason. Banks operate on the assumption that savers will not need their savings at any given time. If a substantial proportion of savers at a bank suddenly want their money back, banks then have no choice but to sell illiquid assets (i.e. those not easily converted into cash at fair market value) at low prices to return the money to savers. This action will result in the bank incurring losses that can then cause panic among savers and ultimately lead to a bank run and collapse.

How can regulation reduce bank runs? 

As Prof Douglas Diamond often says, fear of fear itself is a problem. The possibility of a bad equilibrium creates a role for public policy to reduce the risk of bank runs. Governments and quasi-governmental entities like central banks can prevent the self-fulfilling panics that fuel such runs by acting as lenders of last resort, insuring bank deposits, and implementing liquidity regulation. In this regard, the Diamond-Dybvig models showed that banking is a productive activity but also one that creates systemic risk when not backed by a public safety net.

How can banks worsen the economy during financial crises? 

While it is sensible for banks to both accept deposits and issue loans, these services raise the question of whether the banking system poses any problems for the economy. In a 1983 paper, Dr Ben Bernanke argued that the entire economy can suffer when banks fail. He emphasised the importance of maintaining lending capacity and credit availability since research has shown that the loss of loans has an independent effect on the economy. During the 1929 Great Depression, for instance, smaller firms and farmers who relied heavily on bank loans fared worse than larger firms with non-bank sources of credit. More broadly, survey evidence also suggests that the unavailability of new bank credit and pressure on borrowers to repay loans can cause stress in the economy. Dr Bernanke's work sparked further research into the significance of shocks to bank lending as a primary source of instability. This focus on preserving lending capacity and credit availability guided policymaker actions during the 2008 Global Financial Crisis.

In summary, the work of the 2022 Nobel Laureates in Economics has deepened our understanding about the role of banks in the economy, explained how financial systems should be regulated, and guided policymakers on how to deal with financial crises. Collectively, these contributions may have prevented, and will continue to prevent, the suffering that would befall humanity in the event of another crisis like the Great Depression in 1929.

For more information, watch the video on 2022 Nobel Prize In Economic Sciences.