The story so far: On October 10, the Royal Swedish Academy of Sciences announced the names of the winners of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022. Three economists were jointly honored with the latest round of prize winners Nobel to be announced this year: former US Federal Reserve Chairman Ben S. Bernanke, PhD, Massachusetts Institute of Technology; Douglas W. Diamond and Philip H. Dybvig, both with Ph.Ds from Yale University. Diamond is a professor of finance at the University of Chicago Booth School of Business, while Dybvig is a professor of banking and finance at Olin Business School at Washington University in St. Louis.

Why were they chosen for the award?

The Nobel in Economics was awarded to Bernanke, Diamond and Dybvig for their “research on banks and financial crises” undertaken in the early 1980s, which formed the foundations of what constitutes most modern banking research. Their analyzes from nearly four decades ago still illuminate efforts to underscore the vitality of banks to keep the economy running smoothly, possible mechanisms to make them more robust in times of crisis, and how bank meltdowns can fueling a wider financial crisis that can rattle economies. Moreover, their work has gone beyond the realm of theory and has had significant practical importance in the regulation of financial markets and the prevention or management of crises. “The winners’ ideas have improved our ability to avoid both severe crises and costly bailouts,” said Tore Ellingsen, chair of the economics prize committee.

What are the main lessons drawn from the work of these economists?

Bernanke, who served as the head of the US Federal Reserve from 2006 to 2014, had analyzed the worst modern economic crisis – the Great Depression of the 1930s which started in the United States but bludgeoned economies around the world for several years – in a 1983 article. He overturned conventional thinking at the time by asserting that bank failures in the 1930s were not just the result of the Depression but, in fact, a contributing factor to the lingering scars of the economic activity. Besides the obvious impact of bank collapses on the fortunes of its depositors, he argued that critical borrower profiles were lost when banks imploded, hampering the ability to channel savings into investments that could have revived the economy more quickly. Previous economic historians had only focused on the failures of these banks as a factor affecting the economy to the extent that there was a contraction in the money supply. Bernanke proved otherwise by using “historical documentary evidence and empirical data to uncover the importance of the credit channel for the spread of depression,” the Academy pointed out.

Diamond and Dybvig, who completed their doctorates at Yale a year apart in the late 1970s, met in 1983 to postulate theoretical models of the role of banks in an economy and what makes them vulnerable to “rushes” on their deposits. While depositors want access to their savings parked with banks at all times, banks don’t keep idle money, invest it and lend it to borrowers for longer terms. This mismatch of mandates in banks’ asset-liability profiles means that even rumors of a bank’s impending collapse could become a self-fulfilling prophecy, as all savers rush to withdraw their money in a hurry, although ‘a bank only keeps part of these savings on hand to deal with the routine. withdrawals of part of their depositor base. To cope with a simultaneous run on withdrawals, a bank would be forced to sell its long-term investments, even at a loss, in the hope that the haemorrhaging of deposits would stop before it ran out of cash. .

What framework did they propose?

The two economists not only offered a logical framework for understanding this Achilles’ heel for banks, but also offered solutions such as deposit insurance or a “lender of last resort” policy that governments can consider to avoid such failures. “When depositors know that the state has guaranteed their money, they no longer need to rush to the bank as soon as rumors start about a bank run,” they explained. Most countries have deposit insurance schemes in place, although they hope and strive to ensure that the possibility of these risk covers being exploited does not occur. The jury responsible for choosing the Nobel Prize said their work had spurred a slew of subsequent studies yielding fundamental new insights into issues such as financial contagion, internal money creation, financial spread and financial regulation.

In a 1984 article, Diamond also demonstrated that banks “play a socially important role as intermediaries between many savers and borrowers” because they are in the best position to assess the latter’s creditworthiness and “ensure that loans are used for good investments. This line of thinking was also part of Bernanke’s analysis. “The theoretical and empirical findings of Bernanke, Diamond and Dybvig are therefore mutually reinforcing. Together, they offer important insights into the beneficial role banks play in the economy, but also how their vulnerabilities can lead to devastating financial crises,” explained the committee that deliberated on the Nobel Prize in Science. economic in a note.

Why have they been selected now?

The global economy is in the grip of a new crisis, just as it emerged from the haemorrhage caused by the COVID-19 pandemic. The International Monetary Fund (IMF) has warned that the ‘worst is yet to come’ and recessionary conditions threaten many countries, as the war in Europe drags on amid a ‘cost of living’ crisis vitiated by food and energy concerns. The Nobel jury’s choices could well be interpreted as a reminder to governments of lessons that would come in handy again as the current tumult unfolds with fears of impending shocks to the banking system. The findings of these economists have proven “extremely valuable to policymakers, as evidenced by the actions taken by central banks and financial regulators to deal with two recent major crises – the Great Recession”. [triggered by the global financial crisis between 2007-09 when shadow banks like Lehman Brothers collapsed] and the economic downturn generated by the COVID-19 pandemic,” he stressed.

Does this have resonance for India?

Indian households as well as policy makers are all too familiar with the bank failures of recent years, from the problems of the Global Trust Bank, a private bank, to the freezing of withdrawals at several cooperative banks. Government and regulatory interventions aimed at maintaining confidence in the banking system have included higher deposit insurance coverage, facilitating takeovers of weaker lenders, and measures to curb bad debts. The main lessons of the work of the Nobel laureates seem to have been adopted by the Indian authorities. But as the government pursues the privatization of banks while aiming to consolidate lenders to create larger entities to fund larger investments and higher growth, maximum regulatory and legislative vigilance is warranted to anticipate any mishaps in the financial sector. As IMF Chief Economist Pierre-Olivier Gourinchas has warned, the risk of miscalibration of monetary, fiscal or financial policies has risen sharply in a context of elevated uncertainty and growing fragilities.