As Benjamin Hemingway, Junior Research Fellow, Faculty of Economics and Business Administration, Vilnius University (VU), points out, the research of Nobel Prize winners has significantly improved our understanding of the role of banks in the economy and why government intervention may be needed to avoid bank collapses in times of crisis such as during the 2007 financial crisis.
Offered a Solution for Bank Depositors
“Banks provide many important economic functions. First, they channel funds from savers to investments. One key issue is that savers would prefer to be able to access their funds at short notice while investments often require a long horizon to bear fruit.” – says Benjamin Hemingway.
According to VU researcher, Diamond and Dybvig show how banks are able to offer a solution to this problem referred to as ‘maturity transformation’. By acting as intermediaries accepting deposits from many savers, banks can allow depositors to access their money when they wish, while offering long-term loans to borrowers.
Financial Stability Safeguarded Institutionally
However, D.W. Diamond and P. H. Dybvig also show how this maturity transformation makes banks vulnerable to rumours about their financial health. If a large number of savers simultaneously run to the bank to withdraw their money, the rumour may become a self-fulfilling prophecy – a bank run occurs and the bank collapses.
“This research by D.W. Diamond and P. H. Dybvig has had important policy implications and highlighted how government-provided deposit insurance and central banks acting as a lender of last resort are able to ensure financial stability in times of crises.” - Benjamin Hemingway emphasises.
Analysing the Great Depression
According to the VU researcher, B. S. Bernanke analysed the Great Depression of the 1930s, the worst economic crisis in modern history. Among other things, he showed how bank runs were a decisive factor in the crisis becoming so deep and prolonged.
When the banks collapsed, valuable information about borrowers was lost and could not be recreated quickly. Society’s ability to channel savings to productive investments was thus severely diminished.
