Three US economists — Ben Bernanke, Douglas Diamond and Philip Dybvig, have been awarded the Nobel in Economics, 2022 for their work on the role of bank in the economy, particularly during financial crisis. The key take away from their work is avoiding bank collapses is vital.

Banks are the intermediaries between the depositors and borrowers. These banks channelize the household savings to borrowers who make investments. Depositors expect their savings to be accessible instantly when the need arises. Borrowers expect the banks not to demand the loans back suddenly. It is maturity transformation process. Banks as intermediaries create liquidity. Deposits are short maturity liabilities. Borrowers investments are long-term assets. In normal course, all depositors do not want their money back at the same time. Banks thus are able to transform these short-maturity funds into long-maturity assets, which are nothing but loans to the borrowers.

There is a possibility of bank runs. Banks are thus vulnerable. There could be a fairly normal recession. It could result into an economic crisis if banks collapse on account of bank runs. Here people are worried about a bank’s survival and rush to withdraw their deposits in large numbers at the same time. If enough people do this simultaneously, the bank’s reserves cannot cover all the withdrawals. It goes bankrupt. In the 1930s, there were bank bankruptcies on account of panic bank runs.

Banks need to be protected from this type of vulnerability. Diamond and Dybvig proposed several measures including government-backed deposit insurance. Deposit insurance can prevent a bank run before it happens. Diamond and Dybvig wrote a paper in 1983 about the fundamental conflicts between the needs of the savers and depositors.

Depositors are assured that the money is safe. In the 1930s, to alleviate the crisis. Federal Deposit Insurance Corporation was set up. In addition, borrowers must be evaluated properly for the safety of the depositors.

Bernanke’s research studied the causes of depression. He wrote an article in 1983 which analyses the Great Depression of the 1930s. Bank’s failures were previously seen as a consequence of financial crisis. After Bernanke’s paper, it was proved that it is exactly the opposite. Bank failures are the cause of financial crisis.

The joint work of these three economists have laid the foundation of modern banking regulations. Their inputs facilitated the government policy in 2008 financial crisis.