Douglas Diamond: The Father of Modern Banking Theory

At a Glance

  • Diamond's groundbreaking work on bank runs and financial crises earn MSRI Prize
  • "We would all be advised to re-read" his work on financial crises

In the finance world, Douglas Diamond’s pioneering work on banking laid the groundwork for almost all modern financial economics research in that area. He played a key role in the development of the innovative and influential Diamond-Dybvig model of bank runs and related financial crises, which demonstrates how an institution with long-maturity assets and short-maturity liabilities may be unstable.

Armed with a Ph.D. in economics from Yale University Diamond dove into high-level ground-breaking work early in his career and maintained an in-depth focus on banking for over 35 years. Colleagues say his core ideas now comprise the vocabulary in which central bankers, regulators and other policy makers speak to address the issues facing banks and other financial intermediaries.

The path to economics wasn’t clear-cut for Diamond. In high school and even in his early undergraduate years at Brown University, Diamond thought he wanted to be a molecular biologist.  Two weeks into his first semester at college he found out his chemistry course was the wrong pre-requisite and began searching for another class. Fortuitously he signed up for Intermediate Micro Economics, which turned out to be quite an advanced course.

Diamond found economics to be “a very logical way to think about the world,” as he puts it. While still pursuing biology he continued taking more economics classes. “The trouble was –economics seemed so easy — it didn’t seem worth studying,” Diamond recalls. Then he learned about the economic theory “comparative advantage,” which boils down on an individual level to: do what you are relatively good at. “I figured out that the fact that economics was easy for me made it a good thing for me to study.” He soon encountered more challenges and difficulty as the coursework progressed and intrigued he decided to major in economics.

His interest in macro and monetary economics deepened after reading Milton Friedman and Anna Schwartz’s A Monetary Policy History of The United States and he became an economics major. Diamond graduated from Brown in 1975 and then earned his Ph.D. at Yale in June 1980. During a summer job in graduate school, he worked in a research division at the Federal Reserve Board in Washington D.C., focusing on how monetary economics related to the banking system. From there he returned to Yale with a fresh focus on finance.

 

Early Ground-Breaking Work: Bank Runs

As a young professor at the University of Chicago in 1983 Diamond published a seminal paper with Philip Dybvig, which became the standard model for analyzing financial crises: Bank Runs, Deposit Insurance, and Liquidity.

“The paper sought to explain why the very function banks provided, of giving people money on demand, ensured that they became susceptible to runs. The paper explained why there was really no alternative way of structuring banks,” explains Raghuram Rajan, the Governor of the Reserve Bank of India, and a co-author with Diamond on many papers.

Diamond’s early bank runs paper demonstrated how demand deposits can insure individuals against liquidity shocks at the same time as the bulk of the deposited funds are invested in long-term, productive projects, explains MIT economics Professor Bengt Holmstrom. “This maturity transformation is socially very valuable, but it also makes banks vulnerable to a run; an equilibrium in which depositors prematurely pull out funds because of the fear that others will do so,” Holmstrom says.

Essentially, the conundrum surrounds the issue that banks allow depositors to withdraw their money on demand or through a model of short-term funding, while the bank invests its funds for the long term, for example through a 30-year mortgage.

“The magic works because a very small fraction of deposits are withdrawn in any given period,” Holmstrom says. “Except when depositors fear that a large fraction withdraws for some reason in which case everyone withdraws and we have a bank run. The bank can’t liquidate its long term investments and will fail due to lack of liquidity. Diamond-Dybvig captured this mechanism in a brilliantly simple model that is the canonical model of banking and has been used over and over in subsequent studies.”

 

The Starting Point

Diamond is credited for creating the framework and developing the basis for how academics study and how policy makers view banks. “Before Doug there was an incomplete picture of banks. There was no explanation as to why they could be fragile institutions. In his first three papers of his career, Doug fleshed this out,” says Gary Gorton, professor of economics at Yale.

For over 30 years Diamond maintained his high level of work. He is the Father of Modern Banking Theory. As I recall, when regulators were dealing with the financial crisis in 2007-2009, many went back to read Doug’s work. In setting regulations now, we would all be advised to re-read it,” says Rajan.

 

The Domino Effect

Diamond has collaborated with Rajan on at least ten projects including the 2005 Liquidity Shortages and Banking Crises paper. The pair wrote a series of papers on unique factors about banks, including assets, liabilities and the role of banks and the role of bank regulators. The widely regarded 2005 paper demonstrated how failures can be contagious in the banking system when a shortage of aggregate liquidity occurs. The research presaged the 2008 global financial crisis and in some ways explained the domino effect which occurred post-Lehman Brothers.

“While other people say they are too connected to fail, our view – written before the crisis – is that the domino effect can work through banks sharing the same common pool of short-term funding sources of liquidity,” Diamond explains.

The 2008 financial crisis featured actual bank and financial intermediary runs, including Lehman and the Reserve Primary money market fund. There would have been many more potential runs had the Fed and other agencies not intervened, Holmstrom says. “Diamond-Dybvig logic makes clear that calm can only be restored through external credible intervention.”

Professor Diamond has spent the majority of his 35-plus year career at the University of Chicago, where he is currently Merton H. Miller Distinguished Service Professor of Finance at the Booth School of Business. He is also the Fischer Black Visiting Professor of Financial Economics at the MIT Sloan School of Management. He has been bestowed with an array of academic honors and paper prizes throughout his career. Most recently he is the 2015 recipient of the CME Group-MSRI Prize in Innovative Quantitative Applications.

Diamond continues to dig deeper as he keeps pushing the football down the field in regards to answering new questions about banks, liquidity, and crises. “Short-term debt has good and bad aspects. It is a good thing used in moderation. But, the financial sector left to its own devices will tend to use too much of it,” he says.

Looking back over his career Diamond notes he is most proud about the “ability to make incremental progress in defining the role of financial institutions and intermediaries and how they impact the economy. I have achieved this through collaboration with great coauthors and with strong feedback from colleagues at the University of Chicago. I try to make progress on getting more ideas out to the people who make policy,” Diamond says.

Today Diamond continues to collaborate, conduct fresh research and write new papers as he focuses on how the financial system affects the macro economy, how regulation impacts the economy and what is a sensible approach to regulation.

Persistent, Focused and Modest

When you ask current and former colleagues and collaborators about Diamond personally, they are not short on praise..

“Doug is one of the smartest individuals it has been my privilege to know,” says Rajan. “He understands complicated ideas in a flash. This is why Ph.D. students, especially those with ideas off the beaten path, love to work with him. He is open to new thought, generous with his time and his advice, and is revered by people he has advised.”.

“Doug has an extraordinary ability to identify key questions and central economic trade-offs. He is very persistent and focused. He will not give up until he is satisfied with the answer,” says Holmstrom. “There are many economists that have written a larger number of papers than he has, but very few if any with such a high percentage and number of influential papers,”

Franklin Allen, a Wharton University of Pennsylvania economics and finance Professor, refers to Diamond as “one of the most charming and modest people that you can imagine,” characteristics that are a nice addition to his larger impact.

Says Allen, “He lives in a world of ideas but ideas that are simple and drive the way we think about the financial world.”

Kira Brecht has been writing and analyzing the financial markets for 20 years. She is a contributor to the Dow Jones commodity newswire and Kitco News. She's also written for Active Trader magazine, Currency Trader magazine, and the Chicago Tribune. You can follow her on Twitter @KiraBrecht

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