MC Explains | Why Ben Bernanke's economics Nobel for bank crisis work is creating a storm

In 1656, the then king of Sweden approved the foundation of Sweden’s first bank, the Stockholms Banco, which also became the first bank to issue bank notes in Europe. However, Banco over-issued notes leading to its liquidation in 1667. In 1668, the Swedish Nobles decided to found the Riksens Ständers Bank, which was later renamed as Sveriges Riksbank in 1867.

In 1968, on its tercentenary, the Sveriges Riksbank decided to award the economics prize in memory of Alfred Nobel. The award itself was the result of an ongoing crisis and conflict between the central bank and the government.

The purpose of mentioning this history is to highlight how failures are central to banks. Banks have failed ever since they were created. It is the first time the Nobel committee has decided to award the prize to three scholars who studied these failures.

What does Ben Bernanke say about banking crises?

In the 1930s, the world economy faced a serious economic contraction called the Great Depression. For many years, it was thought the Great Depression was due to a lack of policy stimulus. The economist John Maynard Keynes had argued that monetary policy was ineffective in such crises as interest rates could not go lower than zero percent, and one needed a large fiscal stimulus. Milton Friedman argued that central banks could create money even when interest rates were zero by buying assets, thereby increasing the money supply.

Bernanke said that while a lack of policy stimulus explains the contraction, it does not explain why the Great Depression continued for such a long time. The economic contraction had led to a large number of bank failures. His argument was that it was this large-scale failure of banks which prolonged the crisis.

Banks were not in a position to channel loans towards productive activities, leading to the crisis becoming more severe in the US.

Banks have special insights into companies, and when a bank fails, all this information is lost. A failed banking system takes many years to repair and the economy performs very poorly in this period. This explains why the Great Depression became such a prolonged crisis.

Bernanke drew his analysis from a deep understanding of economic and monetary history. This prize also shows the importance of history, which is becoming rarer in economic research.

What are Diamond’s and Dybvig’s insights into banking crises?

Bernanke explained what happens when banks fail. Diamond and Dybvig explained why banks fail. In a joint research, hence called the Diamond-Dybvig model, they explain that banks fail when depositors rush for their money. In their model, banks are seen as financial intermediaries that intermediate funds from depositors to loan seekers.

The deposits are for shorter durations whereas loans are typically given for longer durations (technically called the maturity transformation function of banks). The banks are seen as entities that help savers meet investors, and by channeling loans towards good projects, banks help an economy grow.

However, banks are also prone to runs by depositors. In their research, they show that once there is a rumor about a bank’s weakness, it spreads like wildfire, causing a bank run, when depositors literally run for their funds to the bank. As banks lend most of the funds towards long-term projects, the loans cannot be recalled easily to repay the depositors. If the rumour is not addressed, it leads to eventual bank failure.

While many know this is basically how banks fail, the prize-winning duo formalised the model.

They also presented a solution for bank failures via deposit insurance, which was also introduced before their research. In 1933, the US was the first country to adopt deposit insurance, followed by India in 1962. Both adopted deposit insurance after a significant number of banks failed in these countries.

What are the possible controversies around this award?

The Swedish central bank’s decision to award the prize to Ben Bernanke is very interesting as Bernanke has also served as a central banker. He worked as the Chair of the Federal Reserve (the Fed), the US central bank, from 2006 to 2014. While previous awardees have served as advisers to presidents, none really come as close to mainstream policymaking as Bernanke. One other Nobel laureate, Christopher Pissarides, served in the Cyprus central bank from 2000-2007, before getting the Nobel in 2010.

Bernanke’s legacy as a policymaker during the global financial crisis of 2008 is mixed. There are many who praise Bernanke’s role during the crisis and say it was sheer destiny and good luck that someone like him was the Fed Chair at the time. There are others who think he played a major role in creating and furthering the crisis.

Before becoming the Chair, Bernanke was a Federal Reserve board member and part of the team which kept interest rates low, fuelling the housing bubble which eventually led to the crisis.

His policies during the crisis were also questioned as the central bank passed a high monetary stimulus to prevent bank failures. However, the monetary stimulus continued to create financial bubbles in the economy.

In the case of Diamond-Dybvig, the controversy is more around the role of banks. Their model is based on the idea that banks are financial intermediaries that take deposits and then give loans. However, 2014 research by Bank of England economists suggests that banks actually first give loans, which come back as deposits. So banks are not really intermediaries, but creators of money.

The challenge for banks is finding good projects to lend to, not raising deposits. Other central banks, such as the Reserve Bank of Australia, and Bundesbank of Germany, have also written that loans lead to deposits and not the other way round.

While this suggested change in the role of banks does not change the reasons explained by Douglass-Dybvig for bank runs, it requires reflection on the scholarship on banks. The first central bank in the world, Sweden's Sveriges Riksbank, continues to think that deposits lead to loans, whereas the central bank which gave us the idea of central banking, the Bank of England, thinks it’s the other way round.

What does the prize mean for Indian banking?

India has been facing sporadic a banking crises from 2013 where few banks failed. Bernanke’s research shows how once a crisis starts, it can prolong not just banking problems but also lower economic growth over time.

Diamond-Dybvig’s research shows how the weak performance of individual banks like the Punjab and Maharashtra Urban Cooperative Bank and Yes Bank lead to runs, and the banks need to be bailed out by the government. There was also the case of ICICI bank which faced a run in 2008 based on rumours, but the run was stalled by the central bank by issuing a notifcation assuring the sound health of the bank.

Economist and former Reserve Bank of India (RBI) chief Raghuram Rajan seemed to have missed out on the award. He is a leading scholar on banking and has written many research papers with this year’s awardee, Douglass Diamond. The committee has cited 12 of his research papers, which are a significant contribution to the field of banking.