Douglas Diamond: The Father of Modern Banking Theory

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"The magic works because a very small fraction of deposits are withdrawn in any given period," Holmstrom says.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."

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.

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.

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."