The Nobel Prize for Economics in 2022 was awarded to Ben S Bernanke, Douglas W Diamond and Philip H Dybvig for research on banks and financial crises.

Do you know?

• The economics prize is not one of the original five awards created in the 1895 will of industrialist and dynamite inventor Alfred Nobel.
• It was established by Sweden’s central bank and first awarded in 1969, its full and formal name being the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

Why was the Nobel given to these three scholars?

• The research of the three laureates has helped us understand the role of banks in the economy, particularly during financial crises.
• Their research shows why avoiding a bank collapse is very important for the economy.

Which bank did these scholars study?

• 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 banknotes in Europe.
• However, Banco over-issued notes leading to its liquidation in 1667.
• In 1668, the Swedish Nobles decided to found the Riksens Standers 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.

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.

Reasons behind the crisis

• 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.

How is bank failure attributed to the financial crisis?

• 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. But Diamond and Dybvig explained why banks fail.
• In 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.

How bank failure is related to depositors?

• Banks are 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 rumor is not addressed, it leads to eventual bank failure.

Is it Nobel-worthy?

• While many know this is basically how banks fail, the prize-winning duo formalized 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 does the prize mean for Indian banking?

• India has been facing sporadic 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.
• Such 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 notification assuring the sound health of the bank.

You must know this!

• 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 Nobel committee has cited 12 of his research papers, which are a significant contribution to the field of banking.

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