What we can learn about the current crisis from the works of the 2022 Nobel Prize winners in Economics

The Royal Swedish Academy awarded the "Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel" 2022, popularly known as the Nobel Memorial Prize in Economics, to three influential American economists - Ben Bernanke, Douglas Diamond and Philip Dybvig - for their valuable contribution to the research on banks and financial crises. 

This year's prize recognised the research conducted during the early 1980s that enhanced our understanding of banks and bank regulation, as well as how to navigate a financial crisis. The research especially plays a significant role in the present time, as the world is at risk of another financial crisis and banks have a crucial role to play.

The works for which the laureates were recognised by the Nobel committee are two theoretical contributions by Diamond and Dybvig (1983) and Diamond (1984), and an empirical contribution by Bernanke (1983). 

These research works significantly improved our understanding of the central role of banks in times of financial crises and gave insights on the three vital questions in relation to banks: i) What are the essential components of the many activities that banks do? ii) What makes banks the institutions that carry out such responsibilities? iii) What follows when issues such as a financial crisis arise in the economy and what roles do banks have to play at that time? 

While their work did not provide definite answers on how the financial system should be regulated in order to attain stability in the economy, they eventually laid the foundation of modern banking regulations that are followed to manage financial shocks such as the Covid-19 pandemic.

Banks and other non-bank financial institutions work as financial intermediaries for savers or depositors and investors or borrowers. The bank channels savings towards investment. A fundamental macroeconomic accounting principle is that saving equals investment. This should be true at the macro level, but the ability to save and willingness to invest hardly coincides at the individual level. 

This is where banks come to the rescue. To perform this role banks have to simultaneously ensure savers instant access to their deposited money and a long-term loan facility for the borrowers. The bank solves this problem through maturity transformation, which is making money by charging more for a loan than they offer to pay on a deposit, so that it can transform short-term deposits into long-term borrowings. 

Diamond and Dybvig (1983) showed that the combination of these two activities can make banks inherently vulnerable to bank runs if the maturity transformation process backfires. Although it is very unlikely for all depositors to feel the need to withdraw their money at the same time, this can happen during a financial crisis. 

A bank run occurs when large groups of depositors panic, driven by fears that the institution will become insolvent and all race simultaneously to withdraw their money from banks. Even if the insolvency of a bank is merely a rumour, it can eventually cause the bank to collapse. Two plausible preventive mechanisms against such bank runs are deposit insurance provided by the government and the central bank acting as the lender of last resort.

While each investment is associated with some uncertainties, each loan comes with the risk of not being fully repaid. Diamond (1984) analysed the functions of banks that make their existence essential in society. Banks monitor the borrowers to ensure they fulfil their commitment to repaying loans. The return on investment depends on two factors - general uncertainties of any business and the borrower's dedication and sincerity in their businesses. 

In cases where the borrower cannot fully repay the loan, the bank finds it most rational to negotiate and accept a reduced amount as the repayment. However, borrowers would rather take this chance of partial repayment claiming that they cannot repay fully, whether true or not. Hence, banks monitor borrowers to learn about their repayment prospects. This helps avoid bankruptcies and reduce societal costs. Banks monitor borrowers at a certain cost but this process would be way too costly if carried out by individual savers instead. Banks reduce this aggregated monitoring cost with their monitoring expertise and by pooling funds from a portion of savers to diversify loans across many borrowers.

At this point, a sensible question is, who will monitor the banks while banks are monitoring the borrowers. Diamond (1984) argued that monitoring by depositors is not necessary since banks are organised in a certain way. Depositors can force banks to bankruptcy if banks do not repay their deposits. This is where banks get their incentive to monitor the borrowers. 

Banks can effectively perform this by ensuring a well-diversified portfolio of loans to distinct borrowers. It is improbable that all of the loans would default simultaneously, therefore, the bank will not be able to convincingly claim that its borrowers have not repaid the loans. Banks will then use the earnings from profitable investments to pay back their depositors. This benefits society as a whole by reducing the cost of bankruptcy and monitoring.

The dual role of banks (making deposits and making loans), as analysed in the two research articles discussed above, raises the final concern of whether this arrangement of banks can create problems in the economy. The above-mentioned inherent vulnerability of banks and subsequent bank runs can even result in recessions such as the Great Depression of 1930.

Bernanke (1983) analysed the Great Depression and showed that the economy suffers when banks fail to channel savings into productive investments. He also argued that the banking crisis is a cause of an economic downturn, not the other way around, and it can turn a recession into a deep and prolonged depression. 

Important information on borrowers is lost and becomes difficult to recover when banks fail. Fixing a failed banking system may take years, during which the economy may perform poorly. Bernanke's article drew attention to preserving lending capacity and credit availability, which later became the central consideration in formulating policy during the global financial crisis of 2008.

There is still work yet to be done about regulating the financial system effectively so that it can carry out its critical role without sometimes sparking a financial crisis. However, because of the pioneering work done by these laureates and the subsequent studies undertaken based on their work, society today is more prepared to deal with financial crises. 

The possibility that such financial crises will turn into catastrophic long-term depressions has also been reduced. These findings are extremely valuable for policymakers worldwide and played an important role during the onset of Covid-19. Central banks and financial regulators, largely motivated by the three Nobel laureates' research, used these tools to confront the economic downturn during this pandemic.

Farhin Islam is a Research Associate at the South Asian Network on Economic Modeling (SANEM). 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.