Nobel Prize for economics 2022: Banks’ role in financial crises

Source: The post is based on the following articles

“Fed ex-Chair Ben Bernanke shares Nobel with 2 other U.S. economists” published in The Hindu on 11^th October 2022.

“Banks’ role in financial crises” published in the Indian Express on 11^th October 2022.

What is the News?

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2022 — popularly called the Nobel Prize for economics — has been awarded to three US-based economists: Ben S Bernanke, Douglas W Diamond and Philip H Dybvig.

What are the contributions that led to Nobel Prize for economics 2022?

Ben S Bernanke: He analysed the Great Depression of the 1930s. During the crisis, banks collapsed everywhere, people were forced to leave their homes and widespread starvation occurred even in relatively rich countries.

Until Bernanke’s paper, bank failures were seen as a “consequence” of the financial crisis. But Bernanke’s 1983 paper proved it was exactly the opposite— bank failures were the “cause” of the financial crisis.

Bank runs happen when depositors become worried about the bank’s survival, and rush to withdraw their savings. Due to bank runs, the recession of 1929 had turned into a full-fledged banking crisis by 1930 as half the banks went bankrupt.

Now it is understood that the deposit insurance provisions — where a certain amount of one’s deposits in a bank are insured — are a critical tool towards building trust and preventing bank runs.

Douglas W Diamond and Philip H Dybvig:  Since the Global Financial Crisis of 2008, banks are often seen as money-grabbing institutions that exist to profit off borrowers as well as depositors.

But, Diamond and Dybvig’s 1983 paper showed that there are “fundamental conflicts between the needs of savers and investors”.

Savers always want access to at least some part of their savings for unexpected use; this is also called the need for liquidity. They want the ability to pull out money when they need it.

Borrowers need the money for a much longer time. Borrowers cannot function if the money can be demanded back at a short notice.

Diamond and Dybvig showed that these mismatches can best be solved by institutions constructed exactly like banks. They also explained that banks are able to resolve this conflict through the process of maturity transformation.

The bank’s assets have a long maturity, because it promises borrowers that they will not need to pay back their loans early. On the other hand, the bank’s liabilities have a short maturity; depositors can access their money whenever they want.

What are the outcomes of Nobel laureates on the functioning of banks?

Together, their work laid the foundation for modern bank regulations. Their works are crucial to subsequent research that has enhanced the understanding of banks, bank regulation, banking crises and how financial crises should be managed.

Ben S Bernanke used his academic expertise on the Great Depression to work in reviving the American economy after the 2007-2008 financial crisis.

Diamond and Dybvig showed how government guarantees on deposits can prevent a spiralling of the financial crisis.