The financial sector plays a major role in modern economies and banks are the cornerstone of the financial system. They mobilize savings for investment, create opportunities for risk pooling, improve allocative efficiency and reduce transaction costs when funds change hands between borrowers and lenders. Interestingly, the very mechanisms that allow banks to provide these valuable services are also those that sometimes make banks vulnerable to small shocks and market sentiment, triggering a financial crisis and/or bank run with serious consequences. This year, the Nobel Prize in Economics was awarded to three American economists: Ben S. Bernanke, former Chairman of the Federal Reserve; Douglas W. Diamond of the University of Chicago; and Philip H. Dybvig of Washington University in St. Louis for offering a deeper understanding of the genesis, spread, and management of financial crises. Explaining the ideas of Diamond and Dybvig in their seminal 1983 paper on bank runs is a good start.

Even the ideal situation carries a risk

Consider an ideal situation where banks and businesses are honest, banks are healthy with a small volume of non-performing loans, and the economy is not facing major adverse events such as wars, floods, etc Now ask yourself if your deposits in a bank are safe under these ideal conditions. According to Diamond and Dybvig, even in this ideal environment, banks may default on their obligations to depositors due to a different type of risk – the risk associated with the maturity transformation that banks must undertake to be viable.

Their argument is as follows. Consider a bank that accepts deposits from many small savers, like you and me. We may experience a sudden need for cash due to unforeseen circumstances. Therefore, we prefer to place our savings in liquid deposit accounts from which we can withdraw at minimum notice. On the other hand, companies that borrow from the bank prefer loans with longer maturities because they want to invest the money in business activities. To make its operation viable, a bank must pay attention to the needs of both groups of customers. Thus, a bank must transform short-term deposits into long-term loans. Under ordinary circumstances, a bank’s day-to-day operations are unaffected by this mismatch between its assets (loans) and liabilities (deposits) because depositor withdrawals are largely uncorrelated. On any given day, only a fraction of depositors (you and me) face an unexpected need for cash and the need to withdraw money from their accounts.

A framework used as an explanatory

Repeated observations of borrower behavior allow banks to set aside (technically using the law of large numbers) a fraction of the deposits needed to meet daily withdrawal demand and safely release the rest in loans with longer maturities. This process works well as long as each depositor expects other depositors to withdraw only when they have real spending needs. But suppose something changes for the depositors (e.g. economic or political events). This could lead depositors to believe that their deposits are at risk. Such expectations could be totally unfounded or based on a minor event. Now depositors like you and me are knowledgeable and smart. They know that a bank has tied up a significant portion of its deposits in loans that cannot be repaid quickly, and also anticipate that other depositors will want to withdraw their funds.

Therefore, the best strategy for a depositor in these circumstances would be to withdraw their own money before it runs out. Since we’re all smart and think alike, what’s emerging is a perfect recipe for a bank run that can potentially trigger a financial crisis. Incidentally, one way to prevent such crises and runs is to offer deposit insurance, which many governments have in place. You don’t have to be a trained economist to see the beauty and creativity of this explanation – it helped that Diamond and Dybvig were graduate students at Yale in the late 1970s. -Dybvig has been used to explain how financial development affects the rest of the economy and to understand the effects of monetary policy on banks’ portfolio choices. It is one of the few newspapers to have its own Wikipedia page.

The role of the credit market

The other winner, Ben Bernanke, has made significant contributions to our understanding of the role of the credit market in propagating and deepening the effects of shocks. During the Great Depression of the 1930s, nearly 7,000 banks in the United States failed, taking with them $7 billion in depositor assets. One can view bank failures on this scale as the consequence of a deep economic downturn and stop there. However, Bernanke in a 1983 paper argued that the turmoil of 1930-33 reduced the efficiency of the financial sector as a whole by increasing the real costs of market intermediation and making credit more expensive and more difficult to obtain.

Consequently, bank runs played an important role in turning the severe but not unprecedented recession of 1929-1930 into a prolonged depression. Bernanke’s research on the banking sector confirms the belief that favorable credit market conditions are key to mitigating shocks. He put this belief to work as Federal President during the 2008 recession. Overall, the three winners cover different but complementary aspects of financial intermediation and banking.

Niloy Bose and Sudipta Sarangi are both professors of economics at Virginia Tech.