This year, former Chairman of the Federal Reserve Ben Bernanke, University of Chicago Professor Douglas Diamond, and Washington University in St. Louis Professor Philip Dybvig won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel “for research on banks and financial crises.” The Royal Swedish Academy of Sciences, which awards the Nobel prizes in Physics, Chemistry, and Economics every year, cited Bernanke’s research on the 1929 Wall Street crash and subsequent Great Depression as well as Diamond and Dybvig’s seminal 1983 bank run model as the basis of the award. Together, all three laureates’ works answer two very simple questions: Why do we even have banks, given their potential, as well as previous record, to cause massive economic disruptions? Could bank failures be the cause of financial meltdowns and not the consequence?
Bernanke’s research found that financial failures in the 1930s, including a collapse in demand because of unavailability of credit, exacerbated an already wilting economy into the Great Depression. Banks, being intermediaries between borrowers and lenders, had a plethora of information about which borrowers could be trusted to make good on the terms of their loans. However, this information dissipated as many of these banks became insolvent and were shut down. The fear of imminent financial collapse fanned the flames as clients rushed to withdraw their deposits, setting off a domino effect in which banks could no longer pay off their depositors and failed. While this encouraged local lenders, non-banking firms, and retail merchants to lend vis-à-vis banks, these smaller entities could not minimize the cost of transferring credit from lenders to borrowers mostly because they lacked information on creditors. These inefficiencies made it increasingly difficult to gain credit, resulting in savings not fueling the economy as investments. Instead of circulating in the financial system and multiplying, money was proverbially lying under the mattress.
Bernanke built upon Milton Friedman and Anna Schwartz’s theory that the Fed’s inaction in not expanding the money supply worsened the Depression. While still serving on the Federal Reserve Board of Governors, he acknowledged their contribution in a 2002 speech at a conference at the University of Chicago:
“Let me end my talk by abusing slightly my status as an official representative of the Fed. I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
Meanwhile, Diamond and Dybvig’s research derived the optimal solution to a major banking problem: Considering the wide range of deposits, payoff values, and customer patience levels, how should banks decide to split their assets between long-term and short-term? The Diamond-Dybvig model explains that all banks are inherently vulnerable to runs. All it takes is a handful of frightened customers to show up and withdraw their money; this would kick off a cascading cycle of fear among clientele. No one wants to be the last in line and not receive a penny on their investment from a bank which has been forced to liquidate all assets and pay withdrawers off. Diamond and Dybvig recommend deposit insurance as a solution against runs.
The key takeaways from Bernanke, Diamond, and Dybvig’s works are that banks are indispensable, a necessary evil. Bernanke showed how banks alone possess the ability to process and use information about borrowers and lenders, keeping the economy healthy; The Diamond-Dybvig model suggests that banks play the crucial role of generating liquidity by offering liquid deposits against long-term assets. To address these issues in a more modern perspective, I asked Professor Harald Uhlig, Professor of Economics at the University of Chicago, about the role of banks and the Fed in the 2008 financial crisis, especially in comparison with the Great Depression.
“2007 was very different from the Great Depression,” Uhlig said. “The key to the Fed’s response was to provide as much liquidity as possible, lending freely to banks against good collateral, but also buying up the troubled assets. The Fed acted as buyer of last resort, not just lender of last resort.”
The term ‘lender of last resort’ originates in Sir Francis Baring’s 1797 publication Observations on the Establishment of the Bank of England, where he called the Bank of England “the dernier resort” from which other banks could borrow in terms of crisis. English economist Henry Thornton identified in An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain the associated ‘moral hazard’ problem: With the promise of a lender of last resort, banks are incentivised to take greater risks because they have a safety net protecting them from the consequences. Later in the 19th century, Walter Bagehot, an English economist and journalist, formulated his famous rule, later summarized as: “To avert panic, central banks should lend early and freely to solvent firms, against good collateral, and at high rates.” Returning to the 2008 analysis, the Fed being the ‘buyer of last resort’ meant that it would buy up toxic assets left untouched by other investors. Uhlig elaborated on this notion:
“The Fed asked financial institutions to bring them their illiquid assets so that they might consider buying them up. Think of the Diamond-Dybvig model. A bank has some long-term assets but suppose all of their clientele want to withdraw their deposits. The Fed bought the long-term assets, which allowed banks to pay off the withdrawers.”
I then asked what would have happened had the Fed not bailed out insolvent banks.
“Insurance companies could have failed, leaving a large portion of the populace without much needed and desired insurance. Further bank failures would have left millions of people with deposits in these banks bereft of a solution to their credit problem,” responded Uhlig. “The government would have then had to choose winners and losers by transferring assets to those who lost out in the crash, which would have wreaked havoc. We were not clear, however, that this fallout would have necessarily taken place.”
This bailout question became the crux of the Great Recession. The debate of whether financial institutions are too big to fail continues to play out—should government address prevalent concerns about cronyism, moral hazards, and asymmetric information? Bernanke, Diamond, and Dybvig present a compelling argument in favor of a robust but well-regulated banking system. In 2008, then-Fed Chair Bernanke flooded the banks and markets with liquidity in order to keep banks solvent; we therefore avoided a 1930s-style depression. Speculation persists, though, as to where the future of banking is headed, and whether these theories can withstand periodic change in congressional and executive offices as well as the oscillating opinion of economists and laymen across the field.