Nobel Prize in Economics 2022 for the prediction of banking crises

The Sveriges Riksbank, the Swedish Central Bank, is the institution in charge of awarding and announcing the Nobel Prize in Economics, which in 2022 has gone to Ben Bernanke, Douglas Diamond and Philip Dybvig for their work associated with understanding the banking system and, more specifically, its operation during banking crises.

In its deliberation, the Sveriges Riksbank has made a special mention of how important it is to avoid bank collapse. More than 350 years later, the Swedish Central Bank closes a historical circle in which the institution itself was the protagonist in its origins.

Context to the award: Swedish banking history

The Bank of Stockholm was founded in 1657 in imitation of other banks that took deposits from the public. Its general director introduced an innovation: he began to give loans to third parties in exchange for the deposits he collected from the public. Then a problem arose that today represents the raison d’être of modern banking: deposits used to be short-term while, for loans, the term requested was much longer.

The Bank of Stockholm solved this problem in 1661 with a second innovation: credit paper, Europe’s first banknotes. At any time, the equivalent of the value of the banknotes they represented could be exchanged for gold and silver.

Its introduction was an almost instant success but, in less than 10 years, the Bank of Stockholm collapsed, as too many banknotes were printed. This led to the rescue of the bank by the Crown, and the subsequent creation of the Swedish Central Bank, the Sveriges Riksbank, in 1668. In just a decade the first loans were made from deposits, banknotes were invented, the bank panic was discovered and the first central bank appeared.

Discipline, supervision, guarantees

Ben S. Bernanke is the best known of the three laureates. He was president of the Federal Reserve (FED), between 2006 and 2014.

Douglas Diamond and Philip Dybvig are authors of the article, published in 1983, Bank Runs, Deposit Insurance, and Liquidity (Diamond-Dybvig model). The creation of deposit guarantee funds has proven to be a very powerful tool to prevent bank runs. Its premise is that if the depositor is aware that his deposits are insured (up to a specific amount) by the government, the probability of a bank run is significantly reduced.

In an industrial world, the deposit guarantee fund would probably have sufficed. But, in the 1980s, globalization began to arrive and central banks agreed in Basel (Basel I) to ensure a minimum amount of capital based on the quality of the loans they granted.

The world became more complicated with the appearance of the internet and new technologies and in 2004, again from Basel (Basel II), banking regulation was reformed, giving banks autonomy and flexibility, always under the discipline and supervision of their central banks.

2008, the watershed of banking supervision

Alan Greenspan headed the Fed from 1987 to 2006. His was a relatively quiet job. After the terrorist attacks of 11S (2001) he assured that there would be enough liquidity to avoid the collapse and so it was. He also lowered (even more) interest rates, only to start raising them in mid-2004. The real estate bubble and the great systemic crisis of the financial system were prepared.

Bernanke began his mandate in 2006. The financial system was already in serious trouble and the FED had to support the rescue of the insurer AIG and the Bear Stearns Investment Bank, among other entities.

On Friday, September 12, 2008, the Lehman Brothers Investment Bank requested the bailout from the FED, and during that weekend it was denied. On Monday, September 15, he had no choice but to take advantage of the Chapter 11 and request bankruptcy. After this event the world financial system was blown up. In just days Iceland broke and the shock wave was close to taking the euro ahead.

For all this, the Nobel that has just been awarded to Bernanke can become paradoxical. But then the FED reacted, lowered interest rates to zero and began to inject liquidity into the system.

Is Bernanke an expert in predicting banking crises? Analyzing his professional career, it is difficult to find someone with more experience in banking crises. Could the crisis have been managed better? It could also have been managed worse.

The part of the Nobel Prize in Economics 2022 that corresponds to Bernanke is, in any case, a recognition of who was there to keep the banking system standing.

Luis Garvía Vega, Director of the Master’s Degree in Financial Risk Management (MUGRF) at ICADE Business School, Comillas Pontifical University

This article was originally published on The Conversation. Read the original.