The Royal Swedish Academy of Sciences has just announced the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (popularly referred as Nobel Prize in Economics) for the year 2022. Three eminent economists from the US, Ben S Bernanke, Douglas W Diamond and Philip H Dybvig will share the award this year. Among the three, Bernanke is very popular as he steered the US economy and its financial market out of troubled water during the Global Financial Crisis of 2007.

The award this year recognises the contribution of the economists in highlighting the role of banks in a modern economy, and the need to arrest bank failures during an economic crisis.

Bernanke’s two papers, ‘Bankruptcy, liquidity and recession’ and ‘Non-monetary effects of the financial crisis in the propagation of the Great Depression’, which appeared in American Economic Review in 1981 and 1983, respectively, highlighted how failure of banks can aggravate a conventional economic crisis.

The Keynesian explanation on the causes of the Great Depression emphasises on the role of deficient aggregate demand. It is suggested that inadequate investment and consumption expenditure driven by the animal spirits of pessimism led to the Great Depression of early 1930s. Bernanke’s aforementioned works suggest bank failures during this period sustained and aggravated the depressing conditions for a longer time, covering 1929-1933, in the US. During this period, unemployment increased almost 25 per cent and industrial production plummeted by close to 46 per cent.

Failure of banks has the potential to affect the medium-term prospects of economic prosperity. It is because banks play a critical role in mobilisation of savings and converting the savings in an economy into productive investments. Research contributions of Diamond and Dybvig during 1980s have highlighted how banks are useful in this regard.

Banks help in addressing the mismatches in the preferences of the savers and borrowers. The borrowers prefer longer term to maturity for their loans, while the savers require the option to immediately draw upon their savings. This conflict in preferences of the borrowers versus the savers is known as maturity mismatch.

The loan amount sought by the borrowers are generally huge. For example, a home loan seeker may require a loan amount of, say, ₹60 lakh, or a manufacturing firm may require a loan of ₹1,000 crore to start a project. On the contrary, the savings of individuals are generally a few thousands or lakhs. In the absence of banks, it is impossible for the borrower to approach a large number of savers with little acquaintances and pool the loan amount. This is popularly referred as size mismatch.

Due to the maturity and size mismatches, savings and borrowings would not be realised as the preferences of the savers and borrowers are contradictory in nature. Banks, thus, play a critical role in resolving the conflict, and provide options for both the savers and borrowers as per their preferences. The borrower can get loans of larger size with longer maturity, while the savers can place their small savings with banks with the option of withdrawal on demand.

This enables mobilisation of savings and promotion of capital formation, which help in achieving and sustaining economic growth. Empirical evidences also support the above presumptions. In India, after bank nationalisation in 1969, there was a substantial rise in the saving rate from 10-12 per cent in 1960s to nearly 18-20 per cent during late 1970s and 1980s. Similarly, with comprehensive banking reforms, the saving rate increased to 36-38 per cent by late 2010s.

Delegated monitoring

In addition to the above, Diamond, in his 1984 paper ‘Financial intermediation and delegated monitoring’, which appeared in Review of Economic Studies, highlighted the delegated monitoring aspects of banks which benefit bank depositors by avoiding costly monitoring.

Banks monitor their borrowers continuously to ensure prudent use of loans for the stated purpose. This reduces the moral hazard problem — due to diverting of funds obtained through bank loans to any alternative purpose — and the risk of default. This also saves time and effort from duplication of monitoring by numerous bank depositors. This delegated monitoring by banks augments savings and capital formation in the economy.

Furthermore, banks, with their access to large pool of deposits, lend to a variety of economic activities and borrowers with diversified occupation spread over different parts of the country. As taught in finance, diversification of the portfolio reduces overall risk. If a particular borrower is suffering from a negative shock to the particular industry she is exposed to, the related loss can be compensated by the profit earned from the remaining borrowers. Thus, despite loan default by few individual borrowers, bank deposits remain safe.

Finally, in their 1983 paper ‘Bank runs, deposit insurance and liquidity’, which appeared in Journal of Political Economy, Diamond and Dybvig highlight how liquidity problem in a bank can lead to bank run which, in turn, can derail economic prosperity. Government intervention in the form of having deposit insurance can avoid the possibility of bank runs and reduce related economic costs.

They also discussed about the central bank discount window under the lender of last resort (LOLR) facility, which acts similar to deposit insurance by providing liquidity to banks during distress, and reduces the probability of bank runs.

These ideas perhaps helped Bernanke to go aggressive in providing liquidity support to banks, using even unconventional means during the Global Financial Crisis of 2007. The resolve to not allow systemic bank failures saved the world from deepening of the Great Recession and causing a Great Depression-like situation.

The writer is Professor, Department of Economics, Pondicherry University, Puducherry

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