Nobel Prize in Economics 2022 – Explained, pointwise

Introduction

The Nobel Prize in Economics 2022 has been awarded to American Economists Ben Bernanke, Douglas W. Diamond and Philip H. Dybvig. They have been awarded the Nobel for their research on banks and financial crises. Their works laid the groundwork for most of the research undertaken in the field of banking. Their research is still used to show the importance of banks in keeping the economy running smoothly, the role of bank failures in exacerbating the financial crises and the need to make the banks stronger during such crises. Their work has had a big impact on how the financial markets are regulated and how financial crises are dealt with or can be avoided.

What are the important takeaways from the research of winners of Nobel Prize in Economics 2022?

Ben Bernanke

Bank Failure exacerbated the Crisis: Ben Bernanke looked at the Great Depression of the 1930s, which started in the US but transformed to a global crises that lasted for almost 4 years. He argued that bank failures in the 1930s were not just a result of the Depression but also a factor in exacerbating the crisis itself. He argued that failures of banks resulted in inability to channelise savings to investments that could have revived the economy faster. Until Bernanke’s work, bank failures were seen as a ‘consequence’ of the financial crisis. He proved otherwise that bank failures were the ’cause’ of the financial crisis.

Role of ‘Bank Runs’: Bernanke also showed the ‘Bank Runs’ as the main reason for turning of a normal recession into economic crisis. Bank Run refers to a situation when depositors are worried about bank’s sustainability and rush to get their deposits withdrawn from the bank. If lot of depositors withdraw the deposits at the same time, Bank won’t have enough reserves to cover all withdrawal leading to liquidity crisis and eventually insolvency/bankruptcy.

Role of the State: Bernanke also showed that role of the State becomes vital in averting the crisis. Powerful measures by Government are required to prevent bank runs. The deposit insurance provisions (where a certain amount of one’s deposits in a bank are insured) is a critical tool towards building trust and preventing bank runs.

Bernanke’s role as the Chairperson of the Federal Reserve Bank of the US during the financial crisis of 2008 proved to be crucial in tackling the crises.

Douglas Diamond and Philip H. Dybvig

In the 1980s, Diamond and Dybvig worked together to develop theoretical models of the roles of the banks in the economy and the factors that make the banks susceptible to Bank Runs. The difference in tenures of deposits in banks (short) and the loans by banks (long) leads to asset-liability mismatch. Even rumours about Bank’s imminent collapse can trigger panic prompting the depositors to rush to withdraw their money causing a bank run.This eventually leads to bank failure (self-fulfilling prophecy).

In 1984, Diamond also demonstrated that banks serve a “societally important function as intermediaries between many savers and borrowers“. This is because banks are in the best position to evaluate the creditworthiness of borrowers and “ensure that loans are used for good investments“.

Together, the research of Bernanke, Dybvig and Diamond have been instrumental in laying down the foundation for modern bank regulations.

Model proposed by Economists

The economists also proposed potential solutions to averting potential bank crises e.g., measures like deposit insurance and ‘lender of last resort’ policy. Deposit Insurance (by Government) can instil confidence among depositors. When depositors are sure that Government has guaranteed protection of their money, they do not rush to withdraw their deposits from banks thus forestalling bank runs. Most countries now have plans in place to protect bank deposits

What is Asset-Liability Mismatch?

Deposits are liability for banks (i.e., banks have to pay deposits back to depositors when demanded). Deposits are also principal source of funding for banks, which they use to lend money to others. The range of maturity period of deposits is short to medium term (few days to 1-2 years, sometimes up to 5 years). Banks are obligated to pay back the deposit (plus interest) at the time of maturity.

Loans by banks are an asset for them (i.e., banks will receive the loan back from borrower). The maturity period of loans is generally longer compared to deposits. In some cases, like loans for infrastructure projects, the term of loan can be as long as 20 years or more.

Thus there is a difference in the terms of deposits and loans. A situation in which a large number of long-term loans are provided from funds with substantially shorter maturities is referred to as having an asset-liability mismatch. Banks keep a certain proportion of deposits as a reserve to meet such demands of withdrawal of deposits. However, a situation may arise where the reserves set aside may not be enough to meet the withdrawal needs. This may lead to shortage of money to pay back to depositors leading to short liquidity issues.

Consequences of Asset-Liability Mismatch

Interest rate risk and liquidity risk are the biggest repercussions of asset-liability mismatch.

Interest Rate Risk: Shorter-term deposits are repriced faster than loans. If interest rates rise, the bank must pay a greater rate on maturing and new deposits. However, the loans cannot be repriced quickly. As a result, Banks may have to pay more on deposit interests than they earn from interest income from loans.

Liquidity Risk: When loans and deposits have varying maturities, liquidity difficulties may occur. Banks must repay deposits (with interest) at maturity. But they can’t recall loans for repayment. Banks will be unable to service their depositors if they do not acquire fresh deposits or roll over existing accounts. In an emergency, they may pay high interest to raise money.

What causes Bank Run?

A bank run happens when depositors lose their faith in the sustainability of the Bank. Bank runs typically occur due to investors’ panic rather than solvency issues with a bank. If depositors for some reason feel that the financial health of Bank is poor and their money is not safe with the Bank, they may rush to withdraw their deposits from the Bank.

Banks keep a small portion of those savings (deposits) as a separate reserve to meet withdrawal needs. However, if there is large rush for withdrawal it may lead to exhaust the reserve. A bank would be compelled to sell its long-term investments, even at a loss. As more clients withdraw money, there is a greater chance of default, which will cause further withdrawals. Eventually, the Bank not have enough money to pay back the depositors. This leads to liquidity crisis. Even though Bank has assets (loans), they can’t be used to repay as they are due at a later stage. If withdrawals continue to persist, Banks may eventually fail and go bankrupt.

Customer Panic, rather than the bank’s true insolvency, causes a bank run. As more people remove funds, the possibility of bankruptcy rises, prompting even more withdrawals. To deal with the panic, the bank may limit the quantity of withdrawals per customer or halt all withdrawals entirely. In addition, the bank may get more cash from other banks or the central bank in order to grow its cash on hand.

When numerous banks are involved in an unchecked bank run, it produces an industry-wide panic that can lead to an economic crisis.

What is the relevance of the Works of winners of Nobel Prize in Economics 2022 to India?

There have been scare of bank failures/bank runs in India especially in multiple cooperative Banks.

To keep people’s faith in the banking system, the Government and RBI have taken steps like boost deposit insurance, make it easier for weaker lenders to be taken over, and take steps to stop bad loans. The Government is now working to privatize banks and combining them to make them larger entities. This will enable them to make bigger investments (loans to companies) that can boost economic growth. However, Government must take appropriate regulatory steps based on the works of the winners of Nobel Prize in Economics 2022 to ensure that financial sector stays robust and there is no possibility of bank runs.

Conclusion

The works of the winners of Nobel Prize in Economics 2022 have proved to be useful in guiding policy and regulatory framework to avoid potential crisis/mitigating the impact of ongoing crises. Several economists have lauded the role of Ben Bernanke in addressing the banking and financial crisis of 2008. There are valuable lessons for authorities in India to undertake appropriate regulatory steps to avoid such crises in India.

Syllabus: GS III, Indian Economy

Source: The Hindu, The Hindu, Indian Express, Mint, Economic Times