Need for Banks: The 2022 Nobel Prize Winners

Need for Banks: The 2022 Nobel Prize Winners?

Filipe Ferreira, 20th October 2022

In 10th of October of 2022, the economists Ben Bernanke, Douglas Diamond and Philip Dybvig were awarded the Nobel Prize in economics “for their research on banks and financial crisis”.? The framework laid out by the authors shed light on topics such as role of banks and why they benefit society. Up until then, the financial crisis were seen as a consequence of recessions, rather than causes and played a secondary role in economic models, often being treated as exogenous.?

To fully grasp the development of the authors, it is necessary to understand the fundamental idea of banking: Why society needs banks. After all, one of the causes of the sub-prime mortgage crisis is rooted in their irresponsible lending. By resorting to a relatively simple the model, Diamond and Dybvig show how banks can reconcile the wants of two opposing agents.?

On the one hand, there are depositors who wish access to their savings when they need so. On the other hand, there are borrowers demanding funds for long-term projects and, with it, the guarantee that the loan is not to be repaid prior to the investment being finished. The role of banks is precisely to bridge such liquidity gap. In the terminology of Diamond and Dybvig (1983), they perform maturity transformation, as they convert short-term deposits into long-term loans which, otherwise, may have not been funded.??

Indeed, the system works because banks have a unique access to a pool of savers, who are heterogeneous with respect to their liquidity needs. Such behavioural feature is precisely what allows banks to loan out most of its deposits, thus generating investment and employment, with the remaining fraction being kept as reserves to fulfil everyday liquidity requirements.?

Two important remarks must be stated here. First, maturity transformation calls for banking regulation to limit the amount, and the risk of borrowing, undertaken by financial intermediaries.? Second, it becomes clear how the banking system is prone to fail when liquidity needs become homogenous. Typically, this happens in recessions as default rates rise, damaging the bank′s balance sheet and rendering a higher risk of a bank run.?

Whether the latter will materialize, ultimately depends on savers′ beliefs regarding the solvency of the banking system.? If it is expected to fail, people proceed to withdraw their savings, forcing financial intermediaries to fire-sell assets at a loss, and potentially causing a bank that would otherwise not fail, to collapse.1 Therefore, to maintain stability of the financial system, it is of utter importance to effectively manage expectations of depositors. In that sense, following the sub-prime mortgage crisis, fiscal authorities have adopted deposit insurance and central banks have started to act as a lender of last resort.?

An interesting implication of Diamond and Dybvig findings can be found in the financial accelerator theory, proposed by Ben Bernanke. Following an economic downturn, banks cut back on loans to insure against a future bank run, causing investment to fall and further accelerating the initial drop in output. As shown by the author, this resulted in the propagation of what started as an average recession, to one of the largest global economic declines in history, also known as the Great Depression.?

The findings of Bernanke, Diamond and Dybvig go well beyond the ones mentioned here. Importantly, they allowed policymakers to dampen the effects of crisis such as COVID-19, by directly counteracting the drop in credit provided to businesses, resulting in a much smoother recession, and benefiting society as a whole.??

Furthermore, they shed light on role played by the banking system as well as why it is fundamentally fragile and hence calls for regulation. Even so, to this day banking regulation remains a quite debated topic among economists and policymakers.? Excessive red tape can unnecessarily tighten access to credit of households and firms while deposit insurance and central bank acting as a lender of last resort raise moral hazard issues by incentivizing banks to accept riskier projects. Precisely how much should banks be regulated is a question that will certainly entertain the minds of economists in the future.??

Filipe Ferreira