In an article from 1983, this year’s laureates in economic sciences Douglas Diamond and Philip Dybvig develop a theoretical model that explains how banks create liquidity for savers, while borrowers can access long-term financing. Despite this model being relatively simple, it captures the central mechanisms of banking – why it works, but also how the system is inherently vulnerable and thus needs regulation.
Credit image: nobelprize.org
The model in the article is based upon households saving some of their income, as well as needing to be able to withdraw their money when they wish. No one knows in advance whether and when the need for money will arise, but this does not happen at the same time for every household. Meanwhile, there are investment projects that need financing. These projects are profitable in the long-term, but if they are terminated early, the returns will be very low.
In an economy without banks, the households must make direct investments in these projects. Households that need money at short notice will be forced to terminate the projects early, and will consequently experience very poor returns, with only a small amount of money available for consumption.
On the other hand, households that do not need to terminate projects early will enjoy good returns and higher consumption. In such a situation, households will demand a solution that allows them to instantly access their money without this leading to very low returns. Because this solution will be valuable, they will be prepared to accept somewhat lower long-term returns.
In their article, Diamond and Dybvig explain how banks naturally arise as intermediaries and provide this solution. The bank offers accounts where households can deposit their money. It then lends the money to long-term projects. Depositors can withdraw their money when they want, without losing as much as if they had made a direct investment but terminated the project early.
These higher returns are financed by households that save for longer thus giving up some long-term returns, compared to if they had made a direct investment in the project.
Diamond and Dybvig show that this process is how banks create liquidity. The money in the depositors’ accounts is a liability for the bank, while the bank’s assets consist of loans to long-term projects. The bank’s assets have a long maturity, because it promises borrowers that they will not need to pay back their loans early.
On the other hand, the bank’s liabilities have a short maturity; depositors can access their money whenever they want. The bank is an intermediary that transforms assets with long maturity into bank accounts with short maturity. This is usually called maturity transformation.
It is easy to see that maturity transformation is valuable to society, but the laureates also demonstrate that the banks’ business model is vulnerable. A rumour may start, saying that more savers than the bank can cope with are about to withdraw their money. Regardless of whether this rumour is true, it can send depositors rushing to the bank to withdraw their money in case the bank goes bankrupt.
A bank run ensues. In an attempt to pay all its depositors, the bank is forced to recover its loans early, leading to long-term investment projects being terminated prematurely and assets being sold in fire sales. The resulting losses may cause the bank to collapse. The mechanism that Bernanke showed was the trigger for the depression in the 1930s is thus a direct consequence of banks’ inherent vulnerability.
Diamond and Dybvig also present a solution to the problem of bank vulnerability, in the form of deposit insurance from the government. When depositors know that the state has guaranteed their money, they no longer need to rush to the bank as soon as rumours start about a bank run. This stops a bank run before it starts. The existence of a deposit insurance therefore entails, in theory, that it never needs to be used. This explains why most countries have now implemented these schemes.
The 2022 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to Ben S. Bernanke, Douglas W. Diamond and Philip H. Dybvig “for research on banks and financial crises.”
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