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The Ever-reaching Importance of Bank bailout research and the Nobel in favor of it.
The evening of October 10th turned out to be a celebration and controversy when the recipients of the Nobel Memorial Prize in Economics were declared. The sub-discipline that they all represented stood out even further. Ben S. Bernanke (served as Ex-Chairperson of the U.S Fed, 2006-14), Philip H. Dybvig, and Douglas W. Diamond spoke extensively about banks and their role in financial crises through their academic works dating way back to the 1980s.
Key highlights of the contributions of the economists
In 1983, Ben Bernanke examined the Great Depression (1930) that plagued the U.S and world economies and placed gave important results. He shifted the perspective from banks collapsing as a “consequence”, of the Depression to banks being the actual “cause” of the Depression. He projected further that crucial borrower profiles were lost when banks collapsed, making it hard to direct money to projects that could have more quickly recovered the economy. In addition to the apparent effects of bank failures on depositors' financial situations.
He used empirical data and documented historical evidence to show how the importance of credit lines to the "propagation of the depression." The reasons, described by him why the depression deepened: at the time, bank failures damaged valuable banking ties, and the ensuing contraction of the credit supply left the economy with lasting damage. His insights were far-reaching than those of most of his economic historian predecessors writing on the 'depression', such as John Maynard Keynes, Milton Friedman, and Anna Schwartz, who saw banking collapse because of the recession, or simply responsible for contracting the overall money supply, instead of directly affecting macro-investments via ruptured credit arrangements.
A typical recession turned into the worst economic crisis in modern history primarily because of “bank runs”. Bank runs occur when customers hurry to withdraw their savings out of concern for the institution's survival. If enough people do this at once, the bank's reserves will not be enough to pay all the withdrawals, and the bank will go out of business. Bank runs caused the 1929 recession to become a full-fledged banking crisis by 1930 when half the banks failed. It was only after the State (U.S Government) finally introduced aggressive measures to curb future bank runs. Deposit insurance clauses, which cover a portion of one's deposits in a bank, are an important instrument in fostering trust and averting bank runs.
Douglas Diamond and Philip Dybvig proposed theoretical models on banks’ role in the economy and how bank further gets threatened due to frequent ‘runs’ made for deposits. They revealed significant differences in the needs of 'savers' and 'investors.' The requirement for liquidity refers to the desire of savers, to have access, to at least some of their savings for unexpected usage. They want to be able to withdraw money whenever they require it. Borrowers, particularly those seeking a loan to build a house or a road, prefer the fund for a considerably longer period.
They cannot function if they can't receive the money back. Since banks only retain a portion of their savings on hand to cover typical withdrawals from a portion of their depositor base, even rumours about a bank's impending failure could become self-fulfilling prophecies as all savers rush to quickly withdraw their money. A bank would be forced to liquidate its long-term investments, even at a loss, to meet a simultaneous withdrawal surge in the hopes that the deposit leaking will stop before it runs out of cash on hand.
As a solution, they developed further on the ‘deposit insurance’ scheme enhancing the view of the state covering the money of depositors and providing assurance of reimbursing them would act in reducing future bank runs when rumours of a financial crisis gain mainstream attention. Many nations have established deposit insurance schemes in place and have improved their financial regulations in a manner that these risk covers aren’t to be tapped in the future. Diamond further stressed in a 1984 paper that in terms of societal presence, banks still act as watchful intermediaries between savers and borrowers and must improve time and again in assessing borrowers’ credibility and ensuring that the loans disbursed are used for productive investments. Because the bank tells borrowers that they will not have to pay back their loans early, the bank's assets have a long maturity. The bank's liabilities, on the other hand, have a short maturity; depositors can withdraw their funds whenever they wish. The bank acts as a mediator, converting long-term assets into short-term bank accounts. This is commonly referred to as maturity transition.
What’s in it for the world??
The combined work of the trio has inexplicably led to further studies developing the horizons of modern-day banking and financial transactions. Two depressions (the 1930s and 2008) followed by COVID seen when the financial sector got struck, affected every aspect of the economy with its effects deeply riling into the pockets of people. In this digital age, the world is more connected than ever as banking reached the fingertips of people and every transaction is recorded for the same. Today, cross-border bank regulation is made possible due to the realization of these trio of economists and their persistent research on eliminating financial crises.
What this means for India?
Indian households and the economy at large have always been familiar with the event of bank collapses and crises. In a surging dollar trend, the exchange rates of emerging market economies are strained, and they lurk in the shadows of a possibility of an unbalanced economic pattern. The policymakers are watchful of such contingencies and the theories presented by Dybvig, Diamond & Bernanke gain more prominence.
As demonstrated by Diamond and Dybvig, a financial institution that uses demand deposits to finance long-term lending is ideally adapted to meet the competing interests of both savers and borrowers. Liquid assets are required by savers to cover unforeseen expenses. To be able to fund ventures that cannot be prematurely liquidated without incurring significant fees, borrowers need long-term commitments. This is typically done by banks by converting il-liquid assets into liquid ones.
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