The bigger picture of intermediation, financial crises

The financial sector plays a major role in modern economies and banks are the cornerstone of the financial system. They mobilise savings for investments, create opportunities to pool risks, improve allocative efficiencies, and lower transaction costs when funds exchange hands between borrowers and lenders. Interestingly, the very mechanisms that enable banks to offer these valuable services are also those which, at times, make banks vulnerable to small shocks and market sentiments, triggering a financial crisis and/or bank run with severe consequences. This year’s Nobel Memorial Prize in Economic Sciences has been awarded to three American economists — Ben S. Bernanke, the former Federal Reserve Chair; Douglas W. Diamond at the University of Chicago; and Philip H. Dybvig at Washington University in St. Louis for offering a deeper understanding of the genesis, the propagation, and the management of financial crises. Explaining the ideas of Diamond and Dybvig in their 1983 seminal paper on bank runs is a good beginning.

Even the ideal situation has a risk

Consider an ideal situation where banks and firms are honest, banks are healthy with a small volume of non-performing loans, and that the economy is not facing any significant adverse events such as wars, floods, etc. Now, ask yourself if your deposits in a bank are safe under this ideal condition. According to Diamond and Dybvig, even in this ideal environment banks may fail to meet obligations to depositors due to a different kind of risk — the risk associated with maturity transformation which banks have to undertake to be viable.

Their argument goes as follows. Consider a bank that takes deposits from many small savers, like you and me. We may face a sudden need for cash due to unforeseen circumstances. Therefore, we prefer to put our savings in liquid deposit accounts from which we can withdraw at minimum notice. On the other hand, the firms that borrow from the bank prefer loans with longer maturity since they want to invest the money in business activities. To make its operation viable, a bank has to pay attention to the needs of both sets of customers. Thus, a bank has to turn short-term deposits into long-term lending. Under ordinary circumstances, a bank’s day-to-day operation remains unaffected by this mismatch of its assets (loans) and liabilities (deposits) because withdrawals by depositors largely uncorrelated. On a given day, only a fraction of depositors (you and me) faces an unforeseen need for cash and the need to withdraw money from their accounts.

A framework used as an explainer

Repeated observations of borrower behaviour allows banks to set aside (technically by appealing to the law of large numbers) a fraction of deposits needed to meet the daily demand for withdrawal and safely give out the rest as loans with longer maturities. This process works well as long as each depositor expects other depositors to withdraw only when they have real expenditure needs. But suppose something changes for the depositors (economic or political events for example). This could trigger a belief among the depositors that their deposits are at risk. Such expectations could be wholly unfounded or based on a minor event. Now depositors like you and me are informed and smart. They know that a bank has locked a significant fraction of its deposits in loans that cannot be quickly called in, and also anticipating that other depositors will want to withdraw their funds.

Consequently, the best strategy for a depositor under these circumstances would be to withdraw his/her own money before it runs out. Since all of us are smart and we think alike, what emerges is a perfect recipe for a bank run that can potentially trigger a financial crisis. Incidentally, a way to prevent such crises and runs is to offer deposit insurance, which many governments have implemented. One does not have to be a trained economist to see the beauty and creativity in this explanation — it helped that both Diamond and Dybvig were graduate students at Yale in the late 1970s. Additionally, the Diamond-Dybvig framework has been used to explain how financial development affects the rest of the economy and to understand the effects of monetary policy on banks’ portfolio choices. It is one of the few papers to have its own Wikipedia page.

Credit market’s role

The other winner Ben Bernanke, made significant contributions to our understanding of the credit market’s role in propagating and accentuating the effects of shocks. During the great depression of the 1930s, nearly 7,000 banks in the United States failed taking with them $7 billion in depositors’ assets. One can view bank failures at this scale as a consequence of a deep economic downturn and stop there. However, Bernanke in a 1983 paper argued that the disruptions of 1930-33 reduced the effectiveness of the financial sector as a whole by increasing the real costs of intermediating in the market and making credit more expensive and difficult to obtain.

Consequently, bank runs played an important role in converting the severe but not unprecedented downturn of 1929-30 into a protracted depression. Bernanke’s research on the banking sector upholds the belief that favourable credit market conditions are essential for moderating shocks. He did put this belief to work as the Federal Chair during the 2008 recession. Overall, the three winners cover different but complementary aspects of financial intermediation and banking.

Niloy Bose and Sudipta Sarangi are both Professors of Economics at Virginia Tech.