Economics Nobel goes for role of banks in financial crises

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By Pradeep Kumar Panda

Bhubaneshwar, October 11: The Sveriges Riksbank Prize in Economic Sciences for the year 2022 in Memory of Alfred Nobel has been awarded to Ben Bernanke, Douglas Diamond and Philip Dybvig. The laureates explained the central role of banks in financial crises. They have demonstrated the importance of preventing widespread bank collapses.

In the early 1980s, these laureates laid the scientific foundation for modern research into these issues in three articles. Diamond and Dybvig developed theoretical models that explain why banks exist, how their role in society makes them vulnerable to rumours about their impending collapse, and how society can lessen this vulnerability. These insights form the foundation of modern bank regulation.

Through statistical analysis and historical source research, Bernanke demonstrated how failing banks played a decisive role in the global depression of the 1930s, the worst economic crisis in modern history. The collapse of the banking system explains why the downturn was not only deep, but also long-lasting.

Bernanke’s research shows that bank crises can potentially have catastrophic consequences. This insight illustrates the importance of well-functioning bank regulation, and was also the reasoning behind crucial elements of economic policy during the financial crisis of 2008–2009. At this time, Bernanke was head of the US central bank, the Federal Reserve, and was able to put knowledge from research into policy. Later, when the pandemic hit in 2020, significant measures were taken to avoid a global financial crisis. The laureates’ insights have played an important role in ensuring these latter crises did not develop into new depressions with devastating consequences for society.

The work for which Bernanke is now being recognised is formulated in an article from 1983, which analyses the Great Depression of the 1930s. Between January 1930 and March 1933, US industrial production fell by 46 per cent and unemployment rose to 25 per cent. The crisis spread like wildfire, resulting in a deep economic downturn in much of the world.

In Great Britain, unemployment increased to 25 per cent and to 29 per cent in Australia. In Germany, industrial production almost halved and more than one third of the workforce was out of work. In Chile, national income fell by 33 per cent between 1929 and 1932. Everywhere, banks collapsed, people were forced to leave their homes and widespread starvation occurred even in relatively rich countries. The world’s economies slowly began to recover only towards the middle of the decade.

Before Bernanke published his article, the conventional wisdom among experts was that the depression could have been prevented if the US central bank had printed more money. Bernanke also shared the opinion that a shortage of money probably contributed to the downturn, but believed this mechanism could not explain why the crisis was so deep and protracted.

Instead, Bernanke showed that its main cause was the decline in the banking system’s ability to channel savings into productive investments. Using a combination of historical sources and statistical methods, his analysis showed which factors were important in the drop in GDP, gross domestic product. He found that factors that were directly linked to failing banks accounted for the lion’s share of the downturn.

The depression began with a fairly normal recession in 1929 but, in 1930, it developed into a banking crisis. The number of banks halved in three years, in many cases due to bank runs. These happen when people who have deposited money in a bank become worried about the bank’s survival, and so rush to withdraw their savings.

If enough people do this simultaneously, the bank’s reserves cannot cover all the withdrawal and it will be forced to conduct a fire sale of assets at potentially huge losses. Ultimately, this may drive the bank into bankruptcy.

The fear of more bank runs led to falling deposits in the remaining banks, and many banks were afraid to grant new loans. Instead, deposits were invested in assets that could be sold quickly in case depositors suddenly wanted to withdraw their money. These problems with obtaining bank loans made it difficult for businesses to finance their investments, as well as huge financial hardship for farmers and ordinary households. The result was the worst global recession in modern history.

They have significantly enhanced literature on understanding of the role of banks in the economy, particularly during financial crises. An important finding in their research is why avoiding bank collapses is vital.

Modern banking research clarifies why we have banks, how to make them less vulnerable in crises and how bank collapses exacerbate financial crises. Their analyses have been of great practical importance in regulating financial markets and dealing with financial crises.

For the economy to function, savings must be channelled to investments. However, there is a conflict here: savers want instant access to their money in case of unexpected outlays, while businesses and homeowners need to know they will not be forced to repay their loans prematurely. In their theory, Diamond and Dybvig show how banks offer an optimal solution to this problem. By acting as intermediaries that accept deposits from many savers, banks can allow depositors to access their money when they wish, while also offering long-term loans to borrowers.

However, their analysis also showed how the combination of these two activities makes banks vulnerable to rumours about their imminent collapse. If a large number of savers simultaneously run to the bank to withdraw their money, the rumour may become a self-fulfilling prophecy – a bank run occurs and the bank collapses. These dangerous dynamics can be prevented through the government providing deposit insurance and acting as a lender of last resort to banks.

Diamond demonstrated how banks perform another societally important function. As intermediaries between many savers and borrowers, banks are better suited to assessing borrowers’ creditworthiness and ensuring that loans are used for good investments.

Ben Bernanke analysed the Great Depression of the 1930s, the worst economic crisis in modern history. Among other things, he showed how bank runs were a decisive factor in the crisis becoming so deep and prolonged. When the banks collapsed, valuable information about borrowers was lost and could not be recreated quickly. Society’s ability to channel savings to productive investments was thus severely diminished.

(Author is an economist)