Nobel Prize History
The Nobel Prize is the most prestigious award in the scientific world. It was created according to Mr. Alfred Nobel’s will to give a prize “to those who, during the preceding year, have conferred the greatest benefit to humankind” in physics, chemistry, physiology or medicine, literature, and peace.
A sixth prize would be later on created for economic sciences by the Swedish central bank, officially called the Prize in Economic Sciences, often better known as the Nobel Prize in Economics.
The decision of who to attribute the prize to belongs to multiple Swedish academic institutions.
Legacy Concerns
The decision to create the Nobel Prize came to Alfred Nobel after he read his own obituary, following a mistake by a French newspaper that misunderstood the news of his brother’s death. Titled “The Merchant of Death Is Dead”, the French article hammered Nobel for his invention of smokeless explosives, of which dynamite was the most famous one.
His inventions were very influential in shaping modern warfare, and Nobel purchased a massive iron and steel mill to turn it into a major armaments manufacturer. As he was first a chemist, engineer, and inventor, Nobel realized that he did not want his legacy to be one of a man remembered to have made a fortune over war and the death of others.
Nobel Prize
These days, Nobel’s Fortune is stored in a fund invested to generate income to finance the Nobel Foundation and the gold-plated green gold medal, diploma, and monetary award of 11 million SEK (around $1M) attributed to the winners.
Source: Britannica
Often, the Nobel Prize money is divided between several winners, especially in scientific fields where it is common for 2 or 3 leading figures to contribute together or in parallel to a groundbreaking discovery.
Over the years, the Nobel Prize became THE scientific prize, trying to strike a balance between theoretical and very practical discoveries. It has rewarded achievements that built the foundations of the modern world, like radioactivity, antibiotics, X-rays, or PCR, as well as fundamental science like the power source of the sun, the electron charge, atomic structure, or superfluidity.
Understanding Banks
Structures similar to modern banks have been central to economic development since at least the Renaissance and even in some form in Antiquity. Still, their economic role has been hotly debated since their invention.
An ancient view was to judge usury as an important sin, producing money from money instead of “honest” labor.
Meanwhile, banking has often been central to economic prosperity and international influences of regions like Renaissance Italy, Golden Age Flanders, or the British Empire, with the center of finance often moving to (or enriching?) the most powerful nation of an era.
Banks have also often caused and amplified financial crises, with 1929 and the Great Depression a case in point of bank failures leading to severe economic difficulties lasting almost a decade.
In 2022, the Prize in Economic Sciences, or Nobel Prize in Economics, was attributed to researchers who explored the role banks play in the economy and financial crises. Their findings contributed greatly to avoiding a repeat of the Great Depression in subsequent financial crises.
Source: Nobel Prize
What Banks Do
Most people are not very clear about how banks function in the economy. Essentially, they are institutions where you deposit your money, get loans, and withdraw cash. But where the money goes and comes from is often unclear.
The Core Function Of Loans
At the core of the banking system is an economic truth: for the economy to function, it needs long-term investments in things like housing, machinery, human resources, technology, etc.
Such investments are ideally financed by channeling people’s and corporations’ savings to finance them. The provision of loans creates economic value by bringing capital to those who need it, at the right time.
Source: Geeks For Geeks
This, however, creates tension because savers consider their cash savings and investments something they want to be able to access immediately.
Meanwhile, businesses and homeowners need many years to repay, and cannot instantly pay back the loan they have taken.
If borrowers were being forced to repay their loans at any time, this would interrupt any long-term investing.
But at the same time, savers would not want to lend their capital if they can access at least part of it at a moment’s notice. This would reduce the income they can derive from their savings, potentially discouraging the accumulation of capital in society at large.
Economists Douglas W. Diamond and Philip H. Dybvig demonstrated in a 1983 article that banks provide an optimal solution to the problem of mismatched time horizons between savers and borrowers.
A Natural Solution
Banks solve the time horizon mismatch by accepting deposits from many savers at once and putting them together.
Thanks to this merged large pool of savings, individual withdrawals can be made without requiring earlier repayment from a particular borrower.
This is why, as soon as a legal proscription against loans with interest is lifted, banks or similar financial institutions emerge naturally as an intermediary between savers and borrowers. From powerful merchant families like the Italian Medicis to the modern globalized banking corporations.
Source: Britannica
Extra Economic Functions
Another important function banks play is assessing creditworthiness. Banks have the resources and are in a position to gather more data about borrowers than most savers and capital owners would be able to do by themselves.
They also have the manpower, skill, and incentive to keep monitoring the investment over time, keeping track of how well (or poorly) it is going.
This allows banks to act as gatekeepers and aim to optimize the use of loans toward good investments. It also helps reduce the quantity of bad investments and avoid bankruptcies, which are costly to society as a whole.
Banks Creating Money
Diamond and Dybvig also discussed how banks create money that did not exist before.
The banks are essentially converting the previously existing short-maturity saver money into a newly created long-maturity investment.
When a saver withdraws some of his money, he does so from the revenues created by the profits of the long-maturity investment. So in a way, the money withdrawn would not have existed without the loan being done by the bank.
As long as the investments are sound and the loan can be repaid, the overall amount of money and wealth in the economic system increases.
Source: Nobel Prize
A Solution Bringing New Problems
The issue for banks is that while they can handle all the requests for money back from savers in normal circumstances, they hold only a fraction of their liabilities in available cash. Most of the money is locked up in long-term investments.
This is normally not a problem, except if a rumor (justified or not) starts that the bank is doing poorly on these long-term investments.
It makes savers concerned that some of their savings might be lost if they are exposed to these poor investment results. As a result, many of them might want to withdraw their money from the bank at once.
This phenomenon is called a “bank run”, where the bank is forced to recover loans early, leading to premature interruption of long-term investments. This often causes losses and valuable assets being sold below their real value.
Source: Nobel Prize
So, the rumor of a bank crisis can become a self-fulfilling prophecy. The mere rumor of losses on the investments can create a bank run, which creates real losses.
What makes it even worse and increases instability is that only the first savers to rush to the bank will be made whole in case of real troubles. So, there is a built-in incentive to panic first.
Fractional Banking Compounding The Problem
In the modern fractional reserve banking system, banks lend more than they have deposits, as long as they have a minimum percentage of assets held in reserve.
This makes the banks even more important in the process of creating money to support the economy.
As a result, even moderate losses on the invested sums can endanger the savers’ money, and therefore the reputation of the bank.
The Need For State Intervention
The concern of savers regarding individual banks can be justified. And any limit to how much they can withdraw their savings can either trigger a bank run or slow down the whole economy.
Diamond and Dybvig present the solution with a deposit guarantee from the government. By acting as a “lender of last resort”, the state provides a much stronger guarantee on savers’ deposits than any private bank or company could provide.
This removes the risk of a bank run from day one, whether the rumors of losses on the bank’s investments are true or not.
Source: Source: Wall Street Mojo
Learning From Financial Crises
Diamond and Dybvig explained the role of banks in stimulating the economy and offered a practical solution to resolve the age-old issue of bank runs.
This is of crucial importance, as bank runs have been maybe the most common trigger for severe economic downturns in history.
Their contribution to economic science would be completed by Ben Bernanke’s study of financial crises.
In a 1983 article, Ben Bernanke paid close attention to the root causes of the Great Depression that devastated the US and the world’s economy in the 1930s.
The Great Depression would see US industrial production fall by 46% and unemployment rise to 25%. Homelessness, general economic hardship, and even starvation hit the population of developed economies.
Source: Britannica
So understandably, a chief focus of economic science has been to analyze the Great Depression and figure out what policies to implement to prevent it from ever happening again.
Not Enough Money?
Until Bernanke’s work, the general consensus was that the Great Depression could have been avoided by printing more money to fight deflation.
Bernanke argues that while this view is mostly correct, it does not explain the severity of the Great Depression or its extraordinary duration. Instead, he argues that the collapse of many banks led to the loss of the ability to channel capital into productive investments.
What made the Great Depression exceptional is that while it started in 1929 as a stock market crash and a subsequent recession, it quickly evolved in 1930 into a generalized banking crisis.
This concerned not only some banks that took too much risk but the system as a whole. Fifty percent of US banks would close in three years, mostly because of bank runs.
The fall of some banks triggered concerns that others might be at risk as well, triggering a domino effect. The more banks fail, the more bank runs happen, triggering more failure in a self-sustaining loop.
Source: Britannica
This level of risk forced banks to keep assets in cash or loan only to short-term projects. This created financial hardship for companies, suddenly unable to finance their investments, as well as for farmers and households.
Because there was no money to finance productive long-term investments, unemployment rose dramatically and profits could not recover, creating the worst economic depression in history, instead of a “normal” recession.
Bank Crises Cause Economic Decline
Until the research done by Bernanke, the perception among economists was that the bank failure in the 1930s was caused by the economic downturn.
He instead demonstrated that it was the bank failures themselves that worsened the recession and turned it into the Great Depression. So far from being a consequence, they were the root cause of it.
Another aggravating factor was the loss of knowledge about borrowers. Failed banks would not keep track of investments or transfer enough data about their borrowers for them to be evaluated accurately by the surviving banks.
This resulted in 2 problems:
- Productive investment would not find financing, reducing the overall economic activity.
- Low-quality investments might get loans by mistake, leading to losing capital direly needed by other segments of the economy.
A strong argument supporting Bernanke’s theory is that the economy would fail to recover for years.
At least, until the government implemented strong measures to prevent further bank runs, allowing for the banking system to restart its functions of loaning capital to long-term investments and keeping track of borrowers.
Economic Insights Shaping Policy
The new understanding that it was the banking crisis that caused the Great Depression changed the outlook of decision-makers during financial crises.
Bernanke’s findings demonstrated that printing money to stimulate the economy could be insufficient. If banks are left to fail en masse, this would not stop the damages from interrupted long-term investments, as well as the loss of knowledge of borrowers.
This created the modern framework on how to deal with financial crises: not only the extension of deposit guarantee by the government but also proactive actions during crises.
Bernanke would become the Chair of the Federal Reserve of the United States from 2006-2014, overseeing the response to the 2008 financial crisis.
Banking Regulation Solved?
While helpful, the discoveries rewarded with this Nobel Prize do not fully answer how to create “perfect” banking regulations. For example, the deposit guarantee avoids bank runs, but also creates incentives for banks to engage in risky speculations.
If it goes well, the banks’ employees and shareholders cash in the profit. If it goes poorly, the taxpayers are left footing the bill.
Another similar risk is that after saving the bank, the taxpayers’ money might be used to pay excessively large bonuses to the banks’ employees and management.
Meanwhile, while bank runs are avoided, it says nothing about the amount of debt and leverage that is healthy to have in the economy, and when it becomes excessive.
So, further economic insights and regulations are required to reduce the risk of financial crises and their consequences.
Investing In Banking
Banking is the cornerstone of the financial system. It is also a very cyclical sector, with sometimes brutal ups and downs, like the 2008 financial crisis or the onset of the COVID-19 pandemic, as we described in the “5 Worst Bank Collapses in U.S. History.”
It is also a highly profitable sector, often giving generous dividends and other forms of profit distribution to its shareholders, like share buybacks.
You can invest in banks through many brokers, and you can find our recommendations for the best brokers in the USA, Canada, Australia, the UK, and many other countries on securities.io.
If you are not interested in picking specific banks, you can also look into financial & banking ETFs like the Themes Global Systemically Important Banks ETF (GSIB), the SPDR S&P Regional Banking ETF (KRE), or the iShares Global Financials ETF(IXG), which will provide a more diversified exposure to capitalize on banking stocks.
Or you can look at our list of the “10 Largest Banks in the United States of America”.
Banking Stocks
1. JPMorgan Chase & Co.
JPMorgan Chase & Co., an American multinational financial institution, is the largest bank in the United States by national assets and market capitalization. It operates globally, providing a range of services from investment banking and asset management to private and commercial banking. The bank’s history dates back to 1799 when The Bank of the Manhattan Company was founded.
JPMorgan Chase is a key player in investment banking worldwide and is a component of the S&P 500 index. The firm’s lineage includes numerous significant mergers and acquisitions, encompassing historic banks like Chase Manhattan Bank, J.P. Morgan & Co., and Bank One.
Source: The Brand Hopper
It maintains a robust “Fortress Balance Sheet” and is considered systemically important by regulatory authorities due to its size and reach in the financial markets
2. Goldman Sachs Group Inc.
Goldman Sachs Group, Inc., established in 1869, stands as a preeminent global financial institution headquartered in New York. It offers a vast array of financial services across its segments: Global Banking & Markets, Asset & Wealth Management, and Platform Solutions.
This makes the bank more of a premium financial service provider than a general bank, with activity from consumer and retail investors, such as personal loans and mortgages.
The firm’s services cater to a diversified client base, including corporations, financial institutions, governments, and individuals, encompassing areas such as financial advisory for mergers, acquisitions, and restructurings, client execution activities, asset management, wealth advisory services, and investment solutions.
Goldman Sachs also provides innovative solutions through its Platform Solutions segment, offering credit cards and point-of-sale financing alongside corporate and institutional client services.
The company’s extensive history and commitment to financial innovation have established it as a pivotal player in the capital markets sector, underscoring its role as a systemic linchpin in the global financial landscape.
It is also often described (depending on whom, positively or negatively) as a very influential corporation with plenty of political connections.
