Nobel Research From 40 Years Ago Shines a Light on 2023’s Financial Crises

Governments’ responses to the failure of Silicon Valley Bank and Credit Suisse shows policymakers have further to go to fully learn the lessons of last year’s Laureates’ findings on preventing bank failures fuelling economic crises.

Emerging Speculation

Even as three United States-based economists were being honoured last autumn by the Nobel Prize committee for their research into bank collapses and financial crises, Credit Suisse was already at the centre of a swirl of speculation about its health.

Once a top-10 global bank, shares in the Swiss lender had already fallen by almost 60% over the 12 months running up to the award of the Sveriges Riksbank Prize in Economic Sciences in October 2022.

Just five months later, in March 2023, Credit Suisse was bought by rival Swiss bank UBS for $3.25 billion in a state-brokered rescue. That came just a week after the US government dramatically stepped in to rescue customers of Silicon Valley Bank (SVB).

Avoiding a Bank Run

In both cases, the authorities had acted to prevent a bank run, which could in turn have led to another major economic downturn. At least on the surface, they were following a playbook based on research by the Laureates: former US Federal Reserve chairman Ben Bernanke, Chicago Booth professor Douglas Diamond and Philip Dybvig, professor at Washington University in St. Louis.

When SVB and another US bank, Signature, failed, the US Fed launched an emergency stabilisation fund known as the Bank Term Funding Program (BTFP), which enables banks to borrow cash from the Fed to meet demands for customer withdrawals rather than having to sell safe assets the 10-year US Treasuries it had used to house its clients’ funds.

Diamond/Dybvig: Installation of Insurance Schemes

The BTFP could be said to be the brainchild of Diamond and Dybvig, whose seminal 1983 paper that earned them the Nobel recommended establishing government insurance schemes that would ensure customers did not rush to withdraw their money when they heard rumours about its ill-health.

They warned that if customers did exit en masse, the institution would likely be forced to sell its bonds or loans, which were meant to be paid off fully when they reached maturity, at fire-sale prices. This would lead to the collapse of an otherwise-solvent bank, that in turn could create worries about other banks. So, when, SVB depositors withdrew $42 billion in one day, the US authorities took the extraordinary step of bailing out SVB’s uninsured depositors.

Just as the 2008 global financial crisis (GFC) started after two Bear Stearns hedge fund collapsed triggering a global credit crunch, so the failure of the relatively small SVB and Signature banks fuelled fears among global investors that systemically important banks such as Credit Suisse were also vulnerable.

Bernanke: Scholarship of the Great Depression

Bernanke was awarded the Nobel Prize for his classic 1983 paper in the American Economic Review,  “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. He explained why a mild recession in the US in late 1929 turned into the Great Depression of the 1930s. While credit can help provide growth, if the credit mechanism is badly disrupted it can also be a very adverse development for the economy.

When the GFC hit the US, Bernanke was able to use his scholarship of the Great Depression to guide his leadership of the US Federal Reserve, which acted to prevent bank failures that could cause downturns in economic activity, as had happened seven decades before.

Thanks to this research, policymakers understand they should not let banks collapse because of the potentially devastating second round impacts. This explains the decision of the Swiss authorities to broker an emergency deal to sell the troubled 167-year-old Credit Suisse to its more successful national rival, UBS.

Assessment by a Lindau Alumnus

Dr Alexander Gruber, Lecturer in Economics at the University of St. Gallen in Switzerland and Lindau Alumnus of the 5^th Lindau Meeting on Economic Sciences 2014, said the Laureates’ research had enhanced policymakers’ ability to improve bank stability and manage bank collapses.

“Some of their brilliant findings have already been implemented very successfully,” he said. “Recent policy interventions, for example, show that authorities are willing to act earlier and much more decisively and forcefully this time in order to avoid widespread bank runs.”

But Dr Gruber said that policymakers were overly lenient, excessively complex, and (in some cases) simply wrong in their regulatory and supervisory efforts throughout the last 15 years before this current crisis.

“Authorities therefore now find themselves in yet another historic ‘hostage situation’, in which they are forced to avoid panic in the banking sector by intervening in ways, which violate some of their own rules, and which may exacerbate existing problems going forward.”

He highlighted the decision to fully protect Silicon Valley Bank’s and Signature Bank’s uninsured depositors, who were predominantly entrepreneurs and corporate officers. He said this may increase the risk of “moral hazard” — where a party lacks the incentive to guard against a financial risk due to being protected from any potential consequences.

Too Big to Save?

Furthermore, the decision by the Swiss government to orchestrate a tie-up of UBS and Credit Suisse effectively replaced two institutions, which were already “too-big-to-fail”, by one, which might even be “too-big-to-save”.

“Policymakers must do a much better job at implementing valuable research findings from last year’s Nobel Laureates and fellow academics going forward,” he said. “Only then can we build a stable and productive banking system, which creates enormous long-term economic benefits for all of us.”