Douglas Diamond was awoken by a phone call just before 4 a.m. on October 10. A person with a Swedish accent informed the University of Chicago Booth School of Business finance professor that he’d just won the Nobel Prize in Economic Sciences.
Diamond wasn’t convinced.
“I was thinking it was probably the real thing, but you never know,” Diamond says. He wondered if it might have been one of his friends pranking him.
DIAMOND-DYBVIG MODEL EXPLAINS BANKS’ ROLE IN THE ECONOMY
But it was no prank. Diamond had been named the winner of the 2022 Sveriges Riksbank Prize in Economic Sciences, sharing the prize with his research collaborator Philip Dybvig and former chair of the Federal Reserve Ben Bernanke. By the time three of the five members of the Nobel Committee had congratulated Diamond on the call, he was convinced that “it was probably the real thing,” he tells Poets&Quants.
Diamond’s work examines “why banks are part of the good but unstable part of the financial system,” he explains, adding “I was glad that has been paid close attention to and that the Nobel Committee thought that was worth more attention.”
The Diamond-Dybvig model, which the pair published in 1983, explains banks’ role in the economy and how they can lead to financial crises without proper protections in place. The paper presenting the model, widely cited by economists, describes how banks’ primary role is to create liquidity, which serves the economy while also leaving banks subject to bank runs if too many people try to liquidate their assets at the same time.
LESSONS LEARNED & FORGOTTEN
“That’s why banking and the financial system are unstable,” Diamond says, “but it’s a good thing that they’re unstable because if they were perfectly stable, we wouldn’t have any of these liquid assets being created out of the liquid loans.” The paper laid out a framework for regulating banks and avoiding runs and emphasized the importance of deposit insurance.
Diamond’s work has shaped how economists and policymakers think about financial crises. But he notes that by 2008, the year of the Great Recession, many had forgotten the lessons of his model and the threat bank runs pose.
“The first time I gave that paper with Phil Dybvig at the University of Pennsylvania, someone in the audience said, ‘This paper is a great paper but it should be presented at the economic history workshop because we figured out how to stop financial crises long ago,’” Diamond says. Yet less than two decades later, the Federal Reserve bailed out the Long-Term Capital Management hedge fund to avoid a global financial crisis. And ten years after that, a bank run set off the financial crisis of 2008.
HOW TO AVOID FINANCIAL CRISES
Diamond explains that in the decades leading up to the Great Recession, many within the financial and policy sectors felt the modern economy was no longer vulnerable to bank runs and crises. “They didn’t realize they hadn’t figured it all out,” he says.
The Nobel Committee also referenced another one of Diamond’s influential papers: Financial Intermediation and Delegated Monitoring. Written in 1980 as part of his doctoral dissertation and published in 1984, it was the first paper Diamond ever wrote about banking. It concerned how bankers monitor borrowers, while bankers are held to their financial promises through “the threat of costly punishments.”
In this paper, Diamond describes how banks must be highly leveraged and how a diverse borrower portfolio keeps them protected from runs and failures. He concludes that raising capital requirements for banks after crises is not the best way to prevent them from happening again.
“The whole point of that paper is to say ‘Look, you may want to raise capital requirements on banks somewhat but if you raise them too much, you’ll just kill banking,’” Diamond says.
‘MBA STUDENTS JUST GET THIS’
Diamond is the 97th scholar associated with the University of Chicago to receive a Nobel Prize, and the 33rd to receive the Nobel in economics. Eight current university faculty members are Nobel laureates in economics.
Diamond will be teaching a Financial Markets and Institutions course to Boothies in the spring. A primary focus of the class is financial crises — how they work and how to manage financial institutions during these periods. Diamond teaches students these lessons using the same models that won him the Nobel Prize.
“I found that MBA students just get this,” he says. “They have to work hard to get it, but once they do, they can put it to application. During financial crises, I always get a lot of thank-yous from the students because they could figure out what to do faster than their colleagues.”
He notes that while the theories and models that guided his work are complex, his students are able to understand them and put them into practice when it matters most.
“Many people thought one would be crazy to teach this stuff that was hard, [even] for economists, to MBA students,” Diamond says. “But once you get to the right language, MBA students are just as smart as the smart economists.”
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