Congratulations to Doug Diamond, a long-time consultant to the Richmond Fed’s Research Department, for his Nobel Prize.

Through his own work and through his interaction with Richmond Fed researchers, Diamond, a finance professor at the University of Chicago’s Booth School of Business, has been integral to the Bank’s research on financial crises and banking for three decades.

Diamond shares his award with former Fed Chair Ben S. Bernanke, now of the Brookings Institution, and Philip H. Dybvig of Washington University in St. Louis. In announcing the award, the Nobel committee explained:

Modern banking research clarifies why we have banks, how to make them less vulnerable in crises and how bank collapses exacerbate financial crises. The foundations of this research were laid by Ben Bernanke, Douglas Diamond and Philip Dybvig in the early 1980s. Their analyses have been of great practical importance in regulating financial markets and dealing with financial crises.

For the economy to function, savings must be channelled to investments. However, there is a conflict here: savers want instant access to their money in case of unexpected outlays, while businesses and homeowners need to know they will not be forced to repay their loans prematurely. In their theory, Diamond and Dybvig show how banks offer an optimal solution to this problem. By acting as intermediaries that accept deposits from many savers, banks can allow depositors to access their money when they wish, while also offering long-term loans to borrowers.

However, their analysis also showed how the combination of these two activities makes banks vulnerable to rumours about their imminent collapse. If a large number of savers simultaneously run to the bank to withdraw their money, the rumour may become a self-fulfilling prophecy — a bank run occurs and the bank collapses. These dangerous dynamics can be prevented through the government providing deposit insurance and acting as a lender of last resort to banks.

Diamond demonstrated how banks perform another societally important function. As intermediaries between many savers and borrowers, banks are better suited to assessing borrowers’ creditworthiness and ensuring that loans are used for good investments.

For an overview of Diamond’s seminal work, see his 2007 explanatory article in the Richmond Fed’s former research journal Economic Quarterly. And for a broader perspective on how economists look at fragility in the financial system as a result of Diamond’s work, see this article by Richmond Fed researcher Huberto Ennis and coauthor Todd Keister of Rutgers University.

Related work by Richmond Fed researchers

Wong, Russell. “Why Stablecoins Fail: An Economist’s Post-Mortem on Terra.” Economic Brief No. 22-24, July 2022.

Diamond, Douglas W. “Banking Policy and Monetary Policy,” In Robert G. King and Alexander L. Wolman (ed.), Essays in Honor of Marvin Goodfriend: Economist and Central Banker. Richmond, Va.: Federal Reserve Bank of Richmond, 2022.

Athreya, Kartik. “Understanding the Links Between Policy and Stability.” Feb. 19, 2021.

Haltom, Renee, and Bruno Sultanum. “Preventing Bank Runs.” Economic Brief No. 18-03, March 2018.

Sultanum, Bruno. “Nonparametric Estimation of the Diamond-Dybvig Banking Model.” Economic Quarterly, vol. 102, no. 4, Fourth Quarter 2016, pp. 261-279.

Grochulski, Borys. “Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade.” Economic Quarterly, vol. 99, no. 4, Fourth Quarter 2013, pp. 305-340.

Prescott, Edward S. “Introduction to the Special Issue on the Diamond-Dybvig Model.” Economic Quarterly, vol. 96, no. 1, First Quarter 2010, pp. 1-9.

Ennis, Huberto M. “Economic Fundamentals and Bank Runs.” Economic Quarterly, vol. 89, no. 2, Spring 2003, pp. 55-71.