Background - 

Diamond, Dybvig, and former US Federal Reserve chairwoman Ben S. Bernanke shared the 2022 Nobel Prize in economics for their "research on banks and financial crises" conducted in the early 1980s, which laid the groundwork for much current banking research. They provided a better understanding of financial crises' causes, spread, and management.

Financial crises:

  • The financial sector is critical to modern economies, and banks form the financial system's foundation. They mobilize resources for investment, generate opportunities for risk pooling, promote allocative efficiency, and reduce transaction costs when money is transferred between borrowers and lenders.
  • Surprisingly, the exact processes that allow banks to provide these vital services also render banks subject to minor shocks and market attitudes, potentially precipitating a financial crisis and/or bank run with catastrophic repercussions.
  • In their crucial study on bank runs, Diamond and Dybvig discuss it in detail.

A bank run happens when a large number of customers withdraw money from a bank because they fear the bank will cease to exist in the near future.

Even the best-case scenario contains a risk:

Consider an ideal environment in which banks and enterprises are honest. Banks are healthy with a low amount of non-performing loans. And the economy is not subject to significant unfavorable occurrences such as wars, floods, etc. Now consider if your bank accounts are safe under these perfect conditions. Even in this perfect situation, according to Diamond and Dybvig, banks may fail to satisfy depositor commitments due to a distinct type of risk - the risk associated with maturity transformation, which banks must undertake to remain viable.

A mismatch between assets and liabilities:

  • Their case is as follows. Consider a bank that accepts deposits from many small savers like you and me. We may require money right now due to unanticipated situations. As a result, we prefer to keep our funds in liquid bank accounts that we can access with little notice. On the other hand, firms that borrow from banks prefer loans with longer maturities since they wish to spend the money on commercial operations.
  • A bank must consider the demands of both types of consumers to remain viable. As a result, a bank must convert short-term deposits into long-term loans. Under normal conditions, a bank's day-to-day operations are unaffected by this mismatch between its assets (loans) and liabilities (deposits) because depositor withdrawals are usually uncorrelated. Only a small percentage of depositors experience an unplanned need for cash and the need to remove funds from their accounts on any given day.

As an example, consider the following framework: 

  • Repeated observations of borrower behavior enable banks to lay aside a fraction of the deposits required to fulfill daily withdrawal demand and securely disburse the remainder as loans with longer maturities. This method works successfully as long as each depositor anticipates that other depositors will withdraw only when they have genuine expenditure demands.
  • But what if things change for depositors? (economic or political events, for example). This may cause depositors to believe that their funds are at risk. Depositors are aware that a bank has locked up a considerable portion of its deposits in loans that cannot be called in soon, and they predict that other depositors will also wish to withdraw their monies.
  • As a result, the wisest option for a depositor in these circumstances would be to withdraw his or her own money before it runs out. This bank run has the potential to cause a financial disaster.
  • In addition, several countries have instituted deposit insurance to avert similar crises and runs.
  • For example, in India, the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act requires banks, including regional rural banks, local area banks, foreign banks with branches, and cooperative banks, to obtain deposit insurance through the Deposit Insurance and Credit Guarantee Corporation (DICGC). DICGC now offers insurance coverage of up to Rs 5 lakhs per depositor.

Deposit insurance is a safety cover for losses on bank deposits if a bank fails financially and has no money to pay its depositors and must liquidate.

Credit Guarantee: This is a guarantee that typically provides the creditor with a specific remedy if his debtor does not refund his debt.

  • The Diamond-Dybvig paradigm has been used to describe how financial development impacts the rest of the economy and to comprehend how monetary policy influences bank portfolio decisions.

The credit market's role:

  • Ben Bernanke, the second recipient, contributed significantly to our knowledge of the credit market's role in spreading and amplifying the consequences of shocks. During the 1930s Great Depression, approximately 7,000 banks collapsed in the United States, taking with them $7 billion in depositors' assets. Bank failures of this size can be viewed only as a result of a severe economic slump. However, Bernanke claimed in a 1983 study that the 1930-33 disruptions harmed the overall performance of the financial system by raising the actual costs of market intermediation and making credit more costly and harder to get.
  • As a result, bank runs significantly transformed the severe but not unusual 1929-30 slump into a lengthy depression. Bernanke's banking research supports the view that favorable credit market conditions are critical for mitigating shocks.

Outcome:

  • Overall, the three 2022 Economics Nobel laureates address distinct but complementary elements of financial intermediation and banking, from which the Indian government and regulators might learn a thing or two.