Douglas Diamond

Douglas Diamond

In the realm of economics, few topics captivate and intrigue the curious mind more than financial crises. These complex phenomena have played a significant role throughout history, leaving economists, policymakers, and financial experts grappling with their causes, consequences, and potential remedies.

One person whose work has shed light on these enigmatic events is Douglas Diamond, an economist renowned for his insightful research and rigorous analysis on bank runs, financial intermediation, and the role of regulation. He may not have a crystal ball, but his work does provide some insights and frameworks into how these occurrences can be better prepared for and managed.

Once I started to learn what they actually do for a living in economics, I got really interested.

Diamond first became interested in economics as a young child. Growing up with a single mother meant that Diamond and his mother were not only close, they spoke about all sorts of things. “My mom was interested in figuring out how to invest in mutual funds, which is actually a financial intermediary,” says Diamond. “My mom was a single mom, so she was talking to me about it around age seven. I got exposed to the idea that something to do with finance is something I could think about.”

In high school, he found himself better at math and science than other subjects and was first introduced to economics as a field in a course he took on capitalism. He took his first economics course the year later and was tasked to read Paul Samuelson’s seminal textbook, Economics. While Diamond uses the word “amazing” when referring to the textbook, he felt like economics seemed a bit too easy, so he pursued molecular biology in college.

“I didn't particularly like molecular biology,” he laughs. “But I still took some economics and enjoyed it. I had the interest for a long time, but once I started to learn what they actually do for a living in economics, I got really interested.”

A bank run is when depositors in a bank withdraw their money simultaneously because they anticipate that other depositors will do the same. Whether or not there is a reason to do so is irrelevant. It is the rush of everyone withdrawing their funds at the same time that can lead to a bank collapsing. Bank runs can send shockwaves through the financial system, unsettling even the most stable institutions.

When Diamond and his colleague and co-laureate Philip Dybvig set out to research bank runs, they wanted to explore why banks are subject to runs and why banks write contracts leaving them subject to runs. “We thought in terms of to what extent is this contract something very close to being the best possible mechanism, the best possible set of contracts to do a certain task,” says Diamond. “Like why are banks subject runs and why do we do it in the first place? And the key insight is that it's about having deposits, liabilities of the financial intermediary that are shorter maturity and more liquid than the assets that a financial intermediary has.”

Diamond and Dybvig found that this liquidity mismatch between the assets and liabilities and the reason they’re subject to runs is if everybody demands payment, there’s not enough liquidity in the asset portfolio to give everybody early payment.

“There’s plenty of liquidity to give them payment if they wait a little bit, but there's not enough liquidity in the portfolio to do it in a hurry,” says Diamond. “The banks pay people first come, first serve. So if you think everybody's going to run out, you better get there first. That's why it's a self-fulfilling prophecy. That's a bank run that is caused by the assets being illiquid, not that the bank is insolvent.”

Banks pay people first come, first serve. If you think everybody's going to run out, you better get there first. It's a self-fulfilling prophecy.

This triggered another, unexpected, key learning: it’s really not about the money.

In their model, Diamond and Dybvig assume the bank is always solvent. Not because banks are always solvent but to make the point that you don’t need insolvent banks that are going to fail regardless to have runs. As Diamond puts it, “You could have no cash in the vault and be fine if you could just sell the assets pretty quickly for a good price.”

“The main point was that leaving the bank vulnerable to these runs by giving everybody more liquidity than would be possible to hand out if everybody showed up for it was a way of creating more liquid assets, deposits out of less liquid assets, like loans,” he continues. “So the banks actually created liquidity and provided a type of insurance that you couldn't otherwise get if you just had a financial market.”

The Diamond-Dybvig model first published in 1983 is regarded as a seminal contribution to the field of banking. It also set both economists on a path to be awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 39 years later.

Financial crises and bank runs have always been difficult to predict. The nature of these crises is such that they often occur without much warning. As Diamond explains, “If you knew a financial crisis was going to happen tomorrow, it would happen today.” These crises are low-probability events that occasionally shake the stability of the financial system. One notable aspect is that financial crises and bank runs tend to affect multiple institutions simultaneously, leading to a sense of contagion.

If you knew a financial crisis was going to happen tomorrow, it would happen today.

Diamond identifies two key reasons behind this contagion effect. First, once people observe runs happening in one institution, it triggers a fear that similar runs may occur in other financial institutions. This mindset spreads among depositors and investors, creating a climate of uncertainty. Second, people begin searching for commonalities or weaknesses among various institutions, looking for signs of systemic problems. Diamond emphasizes the importance of understanding the psychological aspect. Fear plays a significant role in financial instability according to Diamond, as the mere presence of fear can trigger a cascade of events.

“Particularly the way I think about part of the problem of financial instability being due to the fear of fear itself is that once you see something that caused fear elsewhere, you start thinking about fear,” he says. “I think that's actually more important than the fact that there's a natural cycle to when financial crises occur.”

While financial crises may have certain cyclical patterns, Diamond believes that the fear factor outweighs the timing of these crises. However, there is another narrative that emerges in the aftermath of a crisis—the delicate balance between too much and too little finance. Following a crisis, individuals and institutions become cautious and adopt more conservative practices. Yet, over time, as memories fade and confidence comes back, the risk can build up again. Diamond says this pattern stems from a combination of short memory, political influences, and complacency among regulators.

“The way to get around that is to make sure that everyone starts to understand periods of calm, those are really the high risk periods, and regulators need to be educated on that. Potentially the public, too,” he says.

Once you see something that caused fear elsewhere, you start thinking about fear. That's actually more important than the fact that there's a natural cycle to when financial crises occur.

Diamond highlights that after the last financial crisis, significant actions were taken to mitigate the risk of future crises. One important step was the formulation of rules and regulations that consider the possibility of closing or restructuring large financial institutions while focusing on the least disruptive and costly methods. The Dodd-Frank Act in the United States incorporated a technical provision known as "single point of entry," which explores how banks and their holding companies interact, aiming to establish a relatively straightforward way of resolving failures without resorting to bailouts. Europe also introduced a strategy known as bail-in, aimed at swiftly addressing financial distress by utilizing funds from unsecured creditors, such as depositors and bondholders, to bolster the bank's capital through restructuring.

While Diamond acknowledges that these measures were significant, he also points to the fact that there are still bank failures, even as recently as 2023. However, the fact that no depositors lost money in these instances, he says, is a positive outcome even if the process wasn’t very smooth.

“I think in principle we did the right stuff worldwide post 2010. We saw in practice that it's a little tricky to rely on regulators,” he says. “Governance within banking is important, but it's very hard to completely solve the issue just by good governance. It’s almost impossible to get to an A+ level.”

When asked if we should expect another financial crash or recession in the near future, Diamond insists predicting the future is not one of his things.

But, when pressed on what the future of finance may look like more generally, Diamond is cautiously optimistic. The move away from paper cash and the rise of digital payments could have positive implications for the banking industry, he thinks, depending on what replaces it. For example, if central banks opt for their own version of digital currencies, that kind of shift could place undue stress on the banking sector, particularly local banks. “The movement toward more electronic payments, debit cards, credit cards and things like that, that plays into the financial institutions' ability to make things more efficient,” he says. “That could potentially enhance the role of financial institutions.”

He thinks more inclusive and diverse financial systems are needed and points to the benefits of cell phone banking in providing access to payment systems for the unbanked, particularly in areas where traditional branch banking isn’t economically viable. Low cost alternatives and competition from such innovations is something he’s excited about. “My guess is that technology will net-net-net improve the role of financial institutions,” he stresses.

Regarding future advancements yet to be fully materialized, Diamond’s interested in decentralized bookkeeping and clearing systems like blockchain, highlighting their potential as game changers in securities exchanges and financial regulation.

“I think that many people are keeping their eye on things like blockchain, which is very separate, even though it's related to the question of creating money in cryptocurrencies,” he says. “Blockchain in the future has a lot of promise. But the popular parts of things that use the blockchain, like Bitcoin and things like that, probably don't.”

I think economics needs to be made more about what it's useful for rather than what its questions are.

During the golden age of economics in the '80s and '90s, Diamond witnessed a seismic shift in economic theory, a transformative era that laid the foundation for his groundbreaking work on financial intermediation. In recent years, the emergence of big data and lightning-fast computers has opened up a new frontier in economics—one that demands a different set of skills.

“To be a really successful young economist today, you need data analysis skills,” he says. But beyond technical expertise, Diamond stresses the fundamental curiosity required for social scientists. “You have to be very curious about why things happen or how much something is happening and what its implications are. You have to have a good understanding of history and what's actually going on in the real world.”

Demystifying economics for a wider population is also a task at hand for the younger generation of economists and requires a focus on two key aspects, according to Diamond. First, it is essential for people to understand the fundamental questions economists address, such as the allocation of scarce resources. However, Diamond believes that it is equally important to showcase the practical applications of economics in shaping government policies and addressing critical issues like climate change or pollution. By providing concrete examples of how economists have contributed to positive change in the world, it becomes easier for individuals to grasp the significance of economics.

“If I was running a public service announcement to recruit more economists, I would make clear that most economists, 95 percent of them, won't actually change the world,” he says. “They'll provide a tool that provides somebody else a tool that provides somebody else a tool to help change the world. I think economics needs to be made more about what it's useful for rather than what its questions are.”