How Nobel Laureates in Economics Guided Policy in the Face of the Banking Crisis

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We all know that the problem of non-performing assets (NPA) of banks was more annoying than any monsoon failure or any of the other irregularities in the natural resource allocation system. The reason is simple. The banking system is the pivot of growth, which it finances. Anyone who needs money has to go through the financial system, where banks play the pivotal role.

It is therefore not surprising that this year’s Nobel Prize in Economics was awarded for work done on banks and financial crises. The two go hand in hand, and while we all want banks, we dread crises as they become self-fulfilling. The subject seems simple as almost everyone knows the banking business. But its potential for triggering growth or crisis, which is its reverse, is immense. The three winners are known to all: Ben Bernanke, Douglas Diamond and Philip Dybvig.

According to them, banks play a very important role of intermediation, which consists of collecting deposits from savers and lending to those who need funds. It is a function carried out in a fairly transparent manner within a well-defined institutional framework throughout the world. The main task for anyone with excess money is how to deploy it. Banks offer savers an option. Likewise, those who want to invest money in projects need financing. Banks provide it. Thus, information asymmetry is handled by the banking system.

In fact, thanks to the fractional reserve system, banks are able to create credit many times over and therefore improve the liquidity of the system. The banks therefore mix the interests of the two groups of players. Custodians have the certainty of being able to withdraw their money whenever they want. Borrowers are assured that they will not be called early to return the money. By pooling money from savers, banks enable continuous “maturity transformation” as the terms of saving and borrowing vary.

This brings up the second reason for having banks around, which is superior knowledge of borrowers. Banks assess the creditworthiness of borrowers and introduce guarantees to ensure loans are repaid and there is less risk of default. Most importantly, the banks closely monitor the loan in terms of the progress of the project the money is borrowed for and ensure that the debt is repaid on time. This ensures that the loan book remains healthy.

The academic research of Nobel laureates focuses on cases of bank runs. Bernanke, in particular, studied the Great Depression, aggravated by bank runs and meltdowns. The question is what if all the savers want their money back at the same time? It’s conceivable because a simple rumor can trigger a race. 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 from other banks also rush to pull out their savings. In such an environment, the bank will reduce its lending, which will slow the wheels of growth and push the economy into a recession.

The winners advocated for deposit insurance in this context. This will ring a bell in India as we also had runs on cooperative banks which caused panic. There have also been cases of bank failures in commercial banks like Global Trust Bank. The panic was still subdued, as it was thought that the Reserve Bank of India (RBI) would protect the interests of deposit holders, which was satisfied by a takeover. On the other hand, in the cooperative banking sphere, there is less comfort.

An interesting thing here is that even ownership of a bank matters. Public sector banks have gone through various phases of challenges over the past two decades, with the NPA crisis being the most recent. There were banks that were under the RBI Rapid Remedies framework. Yet there was never a panic attack, as government ownership provided the stakeholders with the assurance of their survival. This does not apply to private sector banks; and after the Lehman crisis, which turned the “too big to fail” myth into an argument for bailout action, the reaction of savers was different.

The question is: who supervises the banks? There are two parts. The first is internal discipline. Banks ensure that the funds are used wisely as it would benefit their finances. The second is the role of regulation. The central bank has various checks in place to ensure that the rules are followed and the system remains sound.

In fact, a point missed by Bernanke, Diamond and Dybvig is that there remains a conflict of interest between custodians and shareholders that often leans towards the latter when higher risks are taken. This is why regulation is essential to maintain the sanctity of the banking system. When bankers have perverse incentives like stock options and performance-linked paychecks, there’s a tendency to overstep the bounds of caution, perhaps assuming trouble won’t show up. only at a later stage, when the personnel in charge will be different. This is something that RBI also tried to plug.

Although the topic seems rudimentary, this award will spark more discussion and hopefully bring more checks to the financial system across the world.

These are the personal opinions of the author.

Madan Sabnavis is Chief Economist, Bank of Baroda, and author of “Lockdown or Economic Destruction?”

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