Annual Report 2025 - Report - Page 92
Depending on Human Expectation
Banks, Brains, and the Inbuilt
Fragility of Our System
With the economy running efficiently most of the time, small errors can be fatal. In two
#LINOecon sessions, this problem was approached from different angles, focusing on
banks and markets, as well as individual consumers and their choices. Whether you are
a trillion-dollar institution or a single distracted shopper, trust and attention are the
thin threads holding everything together.
For as long as banks have existed, they have been running
a consistent but risky business model. Essentially, they
borrow short and lend long. This maturity transformation is what makes banks useful, helping them to channel idle savings into long-term investments, but it is also
what can make them prone to collapse.
“Banks are fragile and the subject of runs,” Philip H.
Dybvig reminded the Lindau audience, speaking in a
panel. You do not even need fraud or insolvency. Just the
belief that others will panic first. “The interesting thing is
that although the bank is well capitalized and the assets
aren’t risky, the bank can fail,” the Laureate continued.
Douglas W. 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 Sveriges Riksbank Prize in Economic
Sciences in Memory of Alfred Nobel. The two wanted to
strip banking fragility down to its essence, and instead of
focusing on fraud or bad loans, they wondered whether
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 are worth. That
90 | Debating Economics With a Purpose
could give rise to multiple equilibria. And these numerous
equilibria were a way to think about crises.”
Bengt Holmström, who was awarded the 2016 Economics Prize for his work on contracts, brought in his main
concern: “There seem to be people out there who see
money markets as similar to stock markets. However, I
want to underline that they are diametrically opposite.
One aspect is that there are two different ways of getting
to liquidity in these markets. In money markets for example, liquidity refers to information and these markets
are liquid because nobody knows anything, it is symmetric ignorance. Consequently, you should not take lessons
from stock markets into the money markets.”
For younger economists, the Diamond-Dybvig model
was not 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.
“I felt myself thinking back to those conversations
I had overheard 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
