How economics Nobel winners guided policy on banking crisis

The Nobel laureates argued for deposit insurance. This will ring a bell in India because we have had runs on cooperative banks.
The Nobel laureates argued for deposit insurance. This will ring a bell in India because we have had runs on cooperative banks.


  • The subject of banks and financial crisis looks simple but its potential to spark growth or a crisis is immense.

We all know that the non-performing asset (NPA) problem of banks was more irksome than any monsoon failure or any of the other irregularities in the awarding system of natural resources. The reason is simple. The banking system is the fulcrum for growth, which it funds. Everyone who needs money has to go through the financial system, where banks play the pivot.

It is, hence, not surprising that this year’s Nobel Prize in Economics has been awarded for work done on banks and financial crises. The two go together, and while we all want banks, we are apprehensive of crises as they become self-fulfilling. The subject looks simple as almost everyone is familiar with the activity of banking. But its potential to spark growth or a crisis, which is the flip-side, is immense. The three awardees are familiar to all: Ben Bernanke, Douglas Diamond and Philip Dybvig.

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In their view, banks perform a very important role of intermediation, which involves collecting deposits from savers and lending to those who require funds. This is a function performed quite seamlessly through an institutional framework that is well defined across the world. The major task for anyone with surplus money is how to deploy it. Banks provide savers an option. Similarly, those who want to invest money in projects need funding. Banks provide it. Thus, information asymmetry is addressed by the banking system.

In fact, through the system of fractional reserves, banks are able to create credit multiple times and hence enhance liquidity in the system. Banks, hence, blend the interests of both sets of players. Deposit holders have the comfort that they can withdraw their money when they wish. Borrowers are assured that they will not be called upon earlier than the scheduled time to return the money. By pooling the money of savers, banks enable continuous ‘maturity transformation’, as the term periods of savings and borrowings vary.

This brings in the second reason for having banks around, which is superior knowledge of borrowers. Banks evaluate the credit worthiness of borrowers and introduce safeguards to ensure that loans are serviced and there is less chance of default. More importantly, banks closely monitor the loan in terms of progress made in the project for which money is borrowed and ensure debt is serviced on time. This ensures that the loan book stays healthy.

The academic research by the Nobel laureates is on cases of bank runs. Bernanke, especially, studied the Great Depression, worsened by bank runs and collapses. The question is what happens if all savers want their money back at the same time? It’s conceivable as a simple rumour can trigger a run. Banks cannot ask all borrowers to return their money whose contract is linked to a schedule. When such news spreads, panic ensues and deposit holders of other banks also rush to get their savings out. In such an environment, bank will cut down on lending, which in turn will slow down the wheels of growth and lead the economy into a recession.

The laureates argued for deposit insurance in this context. This will ring a bell in India because we have also had runs on cooperative banks, resulting in panic. There have also been instances of bank failures in commercial banking like Global Trust Bank. The panic was still moderate, as it was believed that the Reserve Bank of India (RBI) would protect the interests of deposit holders, which was fulfilled through a takeover. However, in the cooperative banking sphere, there is less comfort.

An interesting thing here is that even bank ownership is important. Public sector banks have been through various phases of challenges in the last two decades, the NPA crisis being the most recent one. There were banks which were under RBI’s prompt corrective action framework. Yet, there was never any panic attack, as government ownership provided stakeholders the assurance of survival. This does not hold for banks in the private sector; and after the Lehman crisis, which turned the myth of being ‘too big to fail’ into an argument for rescue action, the reaction of savers has been different.

The question is: Who monitors banks? There are two parts. The first is internal discipline. Banks ensure that funds are put to good use, as it would benefit their financials. The second is the role of regulation. The central bank has various checks in place to ensure that rules are obeyed and the system stays healthy.

In fact, a point missed by Bernanke, Diamond and Dybvig is that there remains a conflict of interest between deposit holders and shareholders that often tilts towards the latter when higher risks are taken. This is why regulation is critical for maintaining the sanctity of the banking system. When bankers have perverse incentives like stock options and pay-cheques linked with performance, there is a tendency to overextend the boundary of prudence, perhaps on the assumption that problems will only surface at a later stage, when the personnel in charge would be different. This is something RBI has also tried to plug.

While the subject looks rudimentary, this award will ignite more discussion and hopefully bring in more checks on the financial system across the world.

These are the author’s personal views.

Madan Sabnavis is chief economist, Bank of Baroda, and author of ‘Lockdown or Economic Destruction?’

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