Banks, Brains and the Inbuilt Fragility of Our Systems

In some ways, the global economy is like a sports car. It’s sleek, powerful, and engineered for speed; when everything works right, it’s a stunningly efficient machinery. But just like a supercar, what makes it fast also makes it fragile. At high speeds, even small errors can send it spinning out of control. This remarkable duality of the economy was analyzed in great detail at the Lindau Nobel Laureate Meeting.

In two sessions, this problem was approached from different angles, focusing on banks and markets, as well as individual consumers and their choices. But the messages converged: whether you’re a trillion-dollar institution or a single distracted shopper, trust and attention are the thin threads holding everything together.

Keep the Faith

For as long as banks have existed, they’ve been running a consistent but risky business model. Essentially, they borrow short and lend long. Your checking deposit can be withdrawn tomorrow, but your mortgage takes 30 years. This maturity transformation is what makes banks useful, as it enables banks to channel idle savings into long-term investments, but it’s also what can make them prone to collapse.

“Banks are fragile and the subject of runs,” Philip Dybvig reminded the Lindau audience, speaking in a stellar panel. You don’t even need fraud or insolvency. Just the belief that others will panic first. “Everybody knows that if the assets are risky the bank can fail. The interesting thing is that even if the bank is well capitalized and the assets aren’t risky, the bank can fail,” the Laureate continued

Douglas Diamond and Philip Dybvig showed this mathematically in the 1980s, and their work, along with Ben Bernanke’s studies of the Great Depression, earned them the 2022 Nobel Prize in Economics. The two wanted to strip banking fragility down to its essence, and instead of focusing on fraud or bad loans, they wondered what if the danger comes from the very structure of banks themselves, Diamond recalled.

“We tried to come up with the simplest possible model where the only thing that causes the bank run is the notion that everybody knows that the deposits are shorter term than the assets. The assets are illiquid and you can’t sell them or call them in for what they be worth. And then that could give rise to multiple equilibria. And then the multiple equilibria was a way to think about crises.”

Ultimately, the famous Diamond–Dybvig model showed that bank runs doesn’t just affect banks that are genuinely in trouble, confirming what the two Laureates were thinking. If depositors suddenly fear others will rush to withdraw, the panic becomes self-fulfilling; everyone demands their money back at once, the bank is forced to sell assets at fire-sale prices, and a perfectly healthy institution can collapse overnight.

Bengt Holmström, who was awarded the Nobel Prize for his work on contracts, underlined the beautiful simplicity of the model. “In my book, studying bank runs [like Diamond and Dybvig did] is brilliant. It is all about what you can leave out and still say something interesting.”

We Have Not Erradicated Bank Runs

People can withdraw money from banks for all sorts of reasons, Dybvig mentions. Perhaps you want a new car, or you need some expensive treatment or your business is in trouble. But sometimes, people can be genuinely concerned about banks.

The 2008 crisis was a powerful example, and it also showed the importance of what Diamond and Dybvig are saying. Mortgage defaults sparked panic in complex securities, trust evaporated, and the global system buckled. Policymakers scrambled with bailouts and guarantees, proving that without immediate intervention, a liquidity panic can easily spiral out of control. However, the state has become a “lender of last resort” which tempered the crisis. Governments and central banks have the credibility and balance sheets to stop a panic once it starts. When fear drives depositors or investors to flee, the state can step in with guarantees, liquidity, or emergency loans, restoring trust and preventing a temporary shock from spiraling into a full-blown collapse.

For younger economists, the Diamond–Dybvig model wasn’t just an abstract theory in a textbook, it was a lens for making sense of lived experience. Shohini Kundu, now an assistant professor of finance at UCLA, recalled how she first encountered the model while the 2008 crisis was still unfolding around her.

“As he [Diamond] explained the model’s mechanics, I felt myself thinking back to those conversations I had over-heard in 2008. How fragile trust can unravel within an instant. How banks serve as critical institutions that turn short-term savings into long-term investments. And why their collapse reverberates far beyond bank balance sheets into classrooms, into living rooms, into the main streets of communities. But what made the connection even more powerful was learning that Doug and Phil’s work had directly informed federal reserve policy during the crisis. What struck me was the uncanny ways these theoretical models captured so much of the experiences many of us went through during the crisis.”

However, our system is far from immune to such shocks, as we saw with the recent events. In March 2023, Silicon Valley Bank (SVB) collapsed faster than any bank in U.S. history. The bank collapsed from an old-fashioned bank run turbocharged by technology. Twitter rumors, mobile apps, and some imperfect management destroyed the bank, even though, as Diamond says, its “books were solid”. In a matter of hours, depositors pulled out tens of billions of dollars. A whopping $42 billion vanished in a single day, and most of the deposits were uninsured.

Risks, however, don’t just happen at large scales.

The Individual Risk Factor

Daniel McFadden has spent decades studying how people make decisions and how this affects the economy. Our brain, he explained in a lecture, is far from perfect, and so are our senses; these very senses and brain wiring create inconsistencies, and these inconsistencies, in turn, create vulnerabilities.

The Laureate drew a parallel between how a corporation works and how the brain works. The prefrontal cortex operates much like a CEO, taking responsibility for big decisions and long-term strategy. It gets information from other parts of the brain, which in turn rely on what our senses can make of the surrounding world. However, even if this information is perfect (and it’s not), human attention is scarce. Our brains evolved to spot predators in the grass, not to sift through thousands of insurance plans or endless online product listings. Or, as McFadden puts it: signals of threat or opportunity is poorly adapted to systematic and consistent processing of large information flows.”

So we rely on shortcuts. We use defaults, heuristics, and nudges. But those shortcuts have costs. In health insurance markets, for instance, McFadden found that “about 75% of the people … do not pay attention, they just go directly to the default. Those who do pay attention, they still do choose to roll over what they have last year. But the failure to pay attention is a substantial drag… It costs consumers and it costs the government quite a lot of money and it creates a major issue.”

This is all exacerbated by the multitude of commercial options available to us in any given day. McFadden referenced social scientist Herbert Simon who said that “a wealth of information creates a poverty of attention.” Attention is also a scarce resource, and it is also a fragile one.

Ultimately, McFadden echoed a key point also made by the panel. We should accept that fragility isn’t a side effect of the system. Rather, it’s the system itself. Whether we’re talking about banks or the human brains, the things that make them so efficient are also the things that make them vulnerable.

We can use this to build more robust systems. For banks, that means deposit insurance, lender-of-last-resort central banks, smarter stress tests, and accounting rules that reflect reality instead of paper fictions. For consumers, it means protections against predatory nudges, clearer disclosures, and markets that don’t exploit attention gaps. We are wired to altruistically punish deception as an instrument to sustain trust, McFadden says, and we can use that as well.

None of this will eliminate crises, of course. By their very nature, crises are unpredictable. But we can reduce their number and prevent small shocks from turning into catastrophes. We can’t keep our sports car running forever without breakdowns, but we can build better guardrails, add shock absorbers, and teach the driver a little caution. Because speed is thrilling, but survival depends on control.