The bigger picture of intermediation, financial crises

Context: The 2022 Nobel in economics was jointly awarded to Diamond, Dybvig and former U.S. Federal Reserve chairperson Ben S. Bernanke for their “research on banks and financial crises” undertaken in the early 1980s which have formed the foundations of what constitutes most modern banking research. They offered a deeper understanding of the genesis, the propagation, and the management of financial crises.

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.
• 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.

Asset- liability mismatch :

• 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 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 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.
• The depositors know that a bank has locked a significant fraction of its deposits in loans that cannot be quickly called in, and also anticipate 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.
  • This bank run 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.
  • For example, India has the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act under which currently Banks, including regional rural banks, local area banks, foreign banks with branches in India, and cooperative banks, are mandated to take deposit insurance cover with the Deposit Insurance and Credit Guarantee Corporation (DICGC).
  • DICGC now provides insurance cover of maximum Rs 5 lakhs per depositor.
• 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.

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.

Way Forward:

• Overall, the three Economics Nobel winners of 2022 cover different but complementary aspects of financial intermediation and banking, from which Indian government and regulators can learn a lesson or two.

About DICGC:

• It was established in 1978 after the merger of Deposit Insurance Corporation (DIC) and Credit Guarantee Corporation of India Ltd. (CGCI) after passing of the Deposit Insurance and Credit Guarantee Corporation Act, 1961 by the Parliament.
• It is a wholly-owned arm of the Reserve Bank of India (RBI), which offers deposit insurance.
• It insures deposit accounts, such as savings, current, recurring, and fixed deposits up to a limit of Rs 5 lakh per account holder of a bank.
• If a customer’s deposit amount crosses Rs 5 lakh in a single bank, only up to Rs 5 lakh, including the principal and interest, will be paid by the DICGC if the bank turns bankrupt.
• Coverage: Deposits in public and private sector banks, local area banks, small finance banks, regional rural banks, cooperative banks, Indian branches of foreign banks and payments banks are all insured by the DICGC.
• Funds: The Corporation maintains the following funds :
  • Deposit Insurance Fund
  • Credit Guarantee Fund
  • General Fund
• The first two are funded respectively by the insurance premia and guarantee fees received and are utilised for settlement of the respective claims.
• The General Fund is utilised for meeting the establishment and administrative expenses of the Corporation.

Source: The Hindu