Insights into how financial contagion changed how central banks react during a crisis.

This year’s Nobel prize in economics, known as the Sveriges Riksbank Prize in Economic Sciences, has gone to Douglas Diamond, Philip Dybvig and former Federal Reserve Chair Ben Bernanke for their work on banks and how they relate to financial crises.

To explain the work and why it matters, we talked to Elena Carletti, a professor of finance at Bocconi University in Milan.

Why have Diamond, Bernanke and Dybvig been awarded the prize?

The works by Diamond and Dybvig essentially explained why banks exist and the role they play in the economy by channelling savings from individuals into productive investments. Essentially, banks play two roles. On the one hand, they monitor borrowers within the economy. On the other, they provide liquidity to individuals, who don’t know what they will need to buy in future, and this can make them averse to depositing money in case it’s not available when they need it. Banks smooth out this aversion by providing us with the assurance that we will be able to take out our money when it’s required.

The problem is that by providing this assurance, banks are also vulnerable to crises even at times when their finances are healthy. This occurs when individual depositors worry that many other depositors are removing their money from the bank. This then gives them an incentive to remove money themselves, which can lead to a panic that causes a bank run.

Ben Bernanke fed into this by looking at bank behaviour during the great depression of the 1930s, and showed that bank runs during the depression was the decisive factor in making the crisis longer and deeper than it otherwise would have been.

The observations behind the Nobel win seem fairly straightforward compared to previous years. Why are they so important?

It’s the idea that banks that are otherwise financially sound can nevertheless be vulnerable because of panicking depositors. Or, in cases such as during the global financial crisis of 2007-09, it can be a combination of the two, where there is a problem with a bank’s fundamentals but it is exacerbated by panic.