The Nobel Memorial Prize in Economic Sciences was awarded on Monday to Ben S Bernanke, the former Federal Reserve chair, and two other academics for research into banks and financial crises.
Douglas W Diamond, an economist at the University of Chicago, and Philip H Dybvig at Washington University in St Louis won the prize alongside Bernanke, who is now at the Brookings Institution in Washington.
"Fifteen years ago, much of the world stood at the brink of a devastating economic crisis," Tore Ellingsen, chair of the social sciences committee at the Royal Swedish Academy of Sciences, said at a press conference while talking about the Nobel-winning trio.
"Most of us were unprepared for it. However, a few academic economists were both prepared and worried. They had studied the theory of bank runs," he added.
In 1983, Bernanke wrote a paper that broke ground in explaining that bank failures can propagate a financial crisis rather than simply being a result of the crisis.
Meanwhile, in the same year, Diamond and Dybvig wrote a paper on the risks inherent in maturity transformation, the process of turning short-term borrowing into long-term lending. Diamond also wrote about how banks monitor their borrowers, noting that knowledge about borrowers disappears upon bank failures, extending the consequences of the upheaval.
“The laureates have provided a foundation for our modern understanding of why banks are needed, why they’re vulnerable, and what to do about it,” said John Hassler, an economist at the Institute for International Economic Studies at Stockholm University and a member of the prize committee.
The trio's academic contributions provided a foundation for modern research on banking, regulation and crisis management, the Academy said. Their insights were "invaluable" during the global financial crisis as well as during the coronavirus pandemic. They are "highly useful for understanding and regulating an ever changing financial system."
Ben Bernanke led Fed during the worst financial crisis in generations
Bernanke is the former chairman of the US Federal Reserve. He led the US central bank from 2006 to 2014, notably during the 2007-2008 financial crisis.
"His insights broke with conventional wisdom, and now have solid empirical support," the Academy said.
Bernanke, who received a PhD in economics from the Massachusetts Institute of Technology and taught at Princeton University before coming to the Fed as a governor in 2002, drew upon his research about the Great Depression to try to stem the fallout.
He worked with colleagues to set up emergency programs that backstopped various markets on the brink of collapse, from short-term business debt to securitized loans. And alongside the Treasury Department, he used the Fed’s powers to enable bailouts for bank and insurance company portfolios.
Bernanke’s track record on the crisis included controversy. The Fed and Treasury Department allowed Lehman Brothers to fail, which Bernanke has said he and his colleagues believed was their only option.
Some critics have since argued that the investment bank could and should have been saved. The ripple effects of that failure worsened the downturn, which lasted from 2007 to 2009 in the United States and sent activity tumbling around the world.
However, the Fed acted aggressively to try to resuscitate the economy. Under Bernanke’s watch, it began to implement bond-buying policies in which it purchased huge amounts of government-backed debt to lower long-term interest rates.
It also pushed toward greater transparency, beginning to hold quarterly news conferences (which now accompany every rate-setting meeting) and formally adopting an inflation target of 2%.
"His insights broke with conventional wisdom, and now have solid empirical support," the Academy said.
Diamond-Dybvig model
Douglas W Diamond and Philip Dybvig have enormously successful academic careers studying how things can go wrong with banks, and much of their work stems from a highly influential paper they wrote nearly 40 years ago, early in their careers.
The paper showed how banks create liquidity in the economy, and how this liquidity subjects banks to sudden, panicked withdrawals by customers if there is no deposit insurance or other protection.
It is “one of the most widely cited papers in finance and economics,” the University of Washington at St Louis, where Dybvig is an economics professor, wrote in a statement.
The two economists developed the Diamond-Dybvig model showing that deposits used to finance business loans may be unstable and give rise to bank runs. Banks may need a government safety net, like deposit insurance, more than borrowers do.
This topic — how banks work, and how they can slip up, causing broad problems — continues to be relevant. In a video posted in 2019 by the Center for Economic Policy Research, Diamond described how, just before the financial crisis, there was a drastic increase in the number of loans that did not include covenants to help ensure the money would be paid back.
Researchers, he said, were looking into “why, in a boom period, just before the crisis,” was there so little incentive to be careful.