How have the three economists’ insights improved the financial system’s ability to avoid serious crises and bank ‘runs’? Why is their work being rewarded now, almost four decades after it was published? What lessons has India learned from their analysis?

How have the three economists’ insights improved the financial system’s ability to avoid serious crises and bank ‘runs’? Why is their work being rewarded now, almost four decades after it was published? What lessons has India learned from their analysis?

The story so far: On October 10, The Royal Swedish Academy of Sciences unveiled the names of the winners of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022. Three economists were jointly bestowed the honour of the final set of Nobel laureates to be announced this year: former U.S. Federal Reserve chairperson Ben S. Bernanke, a doctorate from the Massachusetts Institute of Technology; Douglas W. Diamond and Philip H. Dybvig, both of whom are doctorates from Yale University. Diamond is professor of Finance at the Booth School of Business, University of Chicago, while Dybvig is Banking and Finance professor at the Olin Business School at Washington University in St. Louis.

Why were they chosen for the award?

The Nobel in Economics has been awarded to Bernanke, Diamond and Dybvig for their “research on banks and financial crises” undertaken in the early 1980s which have formed the foundations of what constitutes most modern banking research. Their analyses nearly four decades ago, still inform efforts to emphasise the vitality of banks to keep the economy functioning smoothly, the possible mechanisms to make them more robust amid crises periods, and how bank collapses can fuel a larger financial crisis that can rattle economies. Moreover, their work went beyond the realm of just theory and has had significant practical import in regulating financial markets and pre-empting or coping with crises. “The laureates’ insights have improved our ability to avoid both serious crises and expensive bailouts,” said Tore Ellingsen, Chair of the Committee for the Prize in Economic Sciences.

What are the key insights gleaned from these economists’ work?

Bernanke, who was the U.S. Federal Reserve chief from 2006 to 2014, had analysed the worst modern economic crisis — the Great Depression of the 1930s that began in the U.S. but bludgeoned economies across the world for several years — in a 1983 article. He turned conventional thinking of the time on its head by arguing that bank failures in the 1930s were not just a result of the Depression but, in fact, a contributing factor to the lingering scars on economic activity. Apart from the obvious impact of collapsing banks on its depositors’ fortunes, he argued that critical borrower profiles were lost when banks imploded, thus hindering the ability to channelise savings to investments that could have revived the economy faster. Previous economic historians had only focused on those banks’ failures as a factor that affected the economy in as much as there was a contraction in money supply. Bernanke proved otherwise by using ‘historical documentary evidence and empirical data to uncover the importance of the credit channel for the propagation of the depression’, the Academy pointed out.

Diamond and Dybvig, who completed their doctorates at Yale a year apart in the late 1970s, came together in 1983 to postulate theoretical models on banks’ role in an economy and what makes them vulnerable to ‘runs’ on their deposits. While depositors want any-time access to their savings parked with banks, banks don’t keep the money idle, investing and lending it onwards to borrowers for longer tenures. This tenure mismatch in banks’ asset-liability profiles mean that even rumours about a bank’s imminent collapse could become a self-fulfilling prophecy as all savers make a beeline to hastily withdraw their money though a bank only keeps part of those savings handy to meet routine withdrawals from a part of their depositor base. To meet a simultaneous withdrawal rush, a bank would be compelled to sell its long-term investments, even if at a loss, in the hope that the deposit bleeding stops before it runs out of cash in hand.

What framework did they propose?

The two economists not only came up with a logical framework for understanding this informally understood Achilles’ heel for banks, but also provided solutions such as deposit insurance or a ‘lender of last resort’ policy that governments can consider to avoid such failures. “When depositors know that the state has guaranteed their money, they no longer need to rush to the bank as soon as rumours start about a bank run,” they explained. Most countries have deposit insurance schemes in place now, even as they hope and strive to ensure the eventuality of these risk covers being tapped doesn’t arise. The jury in charge of picking the Nobel said their work stimulated a flurry of subsequent studies yielding new fundamental insights on issues such as financial contagion, inside money creation, financial propagation, and financial regulation.

In a 1984 paper, Diamond also demonstrated banks’ ‘societally important function as intermediaries between many savers and borrowers’ as they are best placed to assess the latter’s creditworthiness and ‘ensuring that loans are used for good’ investments. This line of thought was also part of Bernanke’s analysis. “The theoretical and empirical findings of Bernanke, Diamond, and Dybvig thus reinforce each other. Together they offer important insights into the beneficial role that banks play in the economy, but also into how their vulnerabilities can lead to devastating financial crises,” the Committee that deliberated on the Economic Sciences Nobel explained in a note.

Why have they been picked now?

The world economy is in the throes of a fresh crisis, just as it was emerging from the COVID-19 pandemic-induced haemorrhaging. The International Monetary Fund (IMF) has warned that the ‘worst is yet to come’ and recessionary conditions loom for many countries, as the war in Europe stretches on amid a ‘cost of living’ crisis vitiated by food and energy worries. The Nobel jury’s picks may well be construed as a reminder to governments about lessons that would come in handy again as the current tumult unfolds with fears about impending shocks to the banking system. These economists’ findings have been proven ‘extremely valuable for policymakers, as is evident in the actions taken by central banks and financial regulators in confronting two recent major crises — the Great Recession [triggered by the global financial crisis between 2007-09 when shadow banks like Lehman Brothers collapsed] and the economic downturn that was generated by the COVID-19 pandemic,’ it underlined.

Does this have any resonance for India?

Indian households as well as policy makers are all too familiar with bank failures in the recent past, starting from the trouble at the privately run Global Trust Bank to freezes in withdrawals at several co-operative banks. Government and regulatory interventions to sustain faith in the banking system have included higher deposit insurance cover, facilitating takeovers of weaker lenders and steps to rein in bad loans. The key learnings from the Nobel Laureates’ work seem to have been embraced by Indian authorities. But as the government pursues privatisation of banks while aiming to consolidate lenders to create larger entities to finance bigger investments and higher growth, utmost regulatory and legislative vigil is warranted to pre-empt any mishaps in the financial sector. As the IMF’s chief economist Pierre-Olivier Gourinchas has warned, the risk of monetary, fiscal or financial policy miscalibration has risen sharply amid high uncertainty and growing fragilities.

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By Dipak

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