Modern Finance Is Efficient. It’s Also Remarkably Vulnerable

Imagine you’re a doctor, but your patient isn’t a person; it’s the global economy. You begin to notice concerning signs: laboured breathing in the credit markets, irregular pulses in interest rates, a touch of fever in inflation indicators. The symptoms don’t always signal an imminent crisis, but sometimes, they point to something much worse than a bad quarter. They suggest that the financial system itself, the circulatory system of capitalism, may be headed toward a crisis.

In some ways, modern financial systems are strikingly robust. But we have learned, again and again, that they can also be surprisingly fragile. Not because of bad actors, though there are plenty, and not necessarily because of technology, but rather because the very things that make finance efficient also make it vulnerable: maturity transformation, liquidity on demand, and the deep entanglement of institutions across the globe.

When confidence falters, the entire edifice can wobble. And we’re wobbling again.

Banking on Faith

The first proto-banks emerged over 2,000 years ago, offering grain loans to farmers and traders who carried goods between cities. Modern banks have grown very different, yet the fundamental principle remains the same. At their core, safeguard assets and allocate capital from those who have it to those who need it.

Yet, fundamentally, banks do something risky. They borrow short (your checking deposit) and lend long (your 30-year mortgage). That makes them useful and also makes them prone to collapse. If depositors lose faith and all try to withdraw their money at once, the bank collapses – even if it’s solvent on paper. This is called a bank run.

Back in the 1980s, economists Douglas Diamond and Philip Dybvig, on the panel of the upcoming Lindau Economics Meeting, formalized this in a model that showed how banks are inherently prone to runs. Diamond and Dybvig showed how a mere rumour of a bank’s trouble can become a self-fulfilling prophecy: worry spreads, people rush to withdraw, and a liquidity problem turns into a solvency crisis as the bank is forced to dump assets at fire-sale prices. The takeaway was simple and powerful: faith matters. You don’t need actual insolvency to trigger a collapse, just the belief that others will panic first.

Ben Bernanke (former Federal Reserve chairman), meanwhile, made the case that bank failures can turn a garden-variety recession into a full-blown depression. Because banks aren’t just middlemen, Bernanke argued. They create credit, manage relationships, and carry valuable information about borrowers. When they disappear, so does the connective tissue of the economy.

Bernanke’s seminal research showed that these bank runs were “a decisive factor in the [Great Depression] becoming so deep and prolonged” because when banks collapsed, “valuable information about borrowers was lost”, choking off the flow of credit to the economy.

Together, these economists were awarded the 2022 Sveriges Riksbank Prize in Economic Sciences in the Memory of Alfred Nobel for helping us understand why banks exist and why they fail. The Nobel Committee recognized that financial crises aren’t just bad luck. Rather, they can be a consequence of the structure of the system.

2008: The Canary and the Coal Mine

Rivers of ink have been spilled over the 2008 financial crisis, but at its core, it was a textbook case of Diamond-Dybvig and Bernanke in action. Mortgage defaults triggered panic in complex financial products. Trust evaporated and suddenly, we were staring into the abyss.

This was no mere “market correction.” It was a full-blown systemic crisis. Policymakers, to their credit, threw everything they had at it. Bailouts, guarantees, quantitative easing, and yet we just barely avoided a second Great Depression. These interventions validated Bernanke’s and Diamond-Dybvig’s point: stopping a financial heart attack quickly is crucial to avoiding economic catastrophe.

The lesson from Bernanke, Diamond, and Dybvig is that financial systems need circuit breakers: deposit insurance, central banks ready to intervene – “whatever it takes” (Mario Draghi) – and a regulatory regime that evolves with the times. Several reforms followed. Banks were told to hold more capital, improve liquidity, and undergo stress tests. They were told to “eat their veggies” and avoid risks. They made progress. Progress fades if it isn’t maintained and the risk migrates.

Technology: Blessing and Curse

For many people, interacting with their bank doesn’t involve going to a building, but opening an app on their laptop or phone. Technology is transforming finance, ensuring faster payments, better access, and smarter risk modeling. But it has its own risks.

AI-powered trading algorithms can cause flash crashes. Shared cloud infrastructure can create systemic vulnerabilities.

Moreover, a decade of low interest rates and lax oversight pushed risk into the so-called “non-bank financial institutions” (NBFIs) – hedge funds, private equity, money market funds, and the rest. NBFIs are sometimes called the ‘shadow banking system’. These aren’t banks, so they don’t face the same scrutiny. But they act like banks, taking risks with other people’s money.

In 2020, at the start of the pandemic, these institutions cracked. The Federal Reserve had to buy corporate bonds, municipal debt, and even step into money markets to prevent a cascade. It worked. But it showed us that shadow banking isn’t just a side plot. It’s central to the story now.

And as we saw with SVB, digital banking can turn a slow-motion panic into a real-time bank run. 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 – made new by technology. Twitter rumors, mobile apps, and a hyper-concentrated depositor base turned hushed concerns into a stampede.

In a matter of hours, depositors pulled out tens of billions of dollars. A whopping $42 billion vanished in a single day. The bank was dead before the regulators even got their pants on.

In the US, the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance to protect consumers’ money in banks up to $250,000 per depositor, and many countries have installed similar safeguards.

But wasn’t FDIC supposed to prevent bank runs? Well, SVB wasn’t your average bank. The vast majority of accounts exceeded $250,000, so they were uninsured by FDIC. This sparked the bank run, and technology (which makes panic more contagious) fanned the flames.

Add to that the rise of crypto. A lot of crypto is financially nonsensical but some of it, like stablecoins, mimics traditional finance (they function like bank deposits) while dodging traditional regulation. When Terra and FTX imploded, the contagion was contained. Next time, we may not be so lucky.

What Keeps the Watchdogs Up at Night?

Behind closed doors, central bankers and supervisors are fixated on a handful of looming threats.  Interest rate shock is a core concern. Central banks raised rates fast to fight inflation. That means unrealized losses on bond portfolios and pressure on highly leveraged borrowers. Some banks are already wobbling. At the same time, global debt levels are sky-high. Emerging markets are especially vulnerable to capital flight and currency crashes. A default could spark another Lehman Brothers moment. Technology, which has become so essential to banks, could also betray us. Financial institutions are juicy targets for hackers. One well-placed cyberattack could freeze payments, shatter trust, and trigger a digital bank run. Hedge funds and private equity carry risk behind opaque walls. Archegos in 2021 showed how one fund’s implosion can slam major banks.

Then, there’s also the insurance problem. Insurance markets are under increasing pressure from extreme weather driven by climate change. This pressure is bound to increase even more as climate change takes its toll.

The Federal Reserve, the European Central Bank, the Bank of England, and others now see their role as more than just setting interest rates. They have become lenders of last resort, stewards of liquidity, and crisis managers-in-chief. During the pandemic, central banks moved with unprecedented speed and scope to stabilize markets and reassure investors. And they arguably prevented a collapse, though at a great cost.

Emerging markets, meanwhile, are on the front lines. Debt distress is rising. Currency volatility is high. And the policy space is limited. A wave of sovereign defaults – or even just a crisis in a large emerging economy—could send shockwaves through the financial system.

Resilience Is Key

Are our safety switches better than they were in 2008? Absolutely. Are we safe? Not even close. The global financial system is like an over-engineered machine, optimized for efficiency, vulnerable to shocks.

Yes, we have better regulations. Yes, banks are more capitalized. But complacency is the enemy. When things are calm, it’s tempting to declare victory and deregulate, let banks chase a bit of risk. That’s exactly what led to the savings and loan crisis; and the dot-com bubble; and the housing crash. You get the idea.

In economics, we talk a lot about efficiency. But confidence is still the key, and perhaps we need to talk more about robustness. A system that works brilliantly until it collapses is not a success; it’s a ticking time bomb.

We can’t eliminate financial crises. But we can prepare and contain them. We can cushion their blow. We can design a system where the failure of one institution doesn’t threaten the global economy.

Faith may be the currency of banking. But regulation is the guarantor of that faith. Let’s not forget that the next time someone tells you that markets can “take care of themselves”.