This year’s Nobel Prize in Economics has been awarded to three American economists for their contributions to explaining the role of modern financial institutions, including the central bank, and for providing information on bankruptcies and “runs”. banking. The three recipients are Ben Bernanke from the Brookings Institution, Douglas Diamond from the University of Chicago and Philip Dybvig from Washington University in St Louis. Bernanke was chairman of the US Federal Reserve from 2006 to 2014. The other two are academics.
The Nobel committee said their work in the early 1980s “significantly improved our understanding of the role of banks in the economy, especially during financial crises. An important finding from their research is why it is vital to ‘avoid bank meltdowns’. They added that it was “invaluable” in steering US (and global) economic systems through the financial crisis of 2008-09 and the downturn of the coronavirus pandemic in 2020-21.
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A key idea that has shaped politics in the 21st century is that banks are not simply neutral intermediaries between savers and borrowers, but provide vital services to the wider economy by gathering information about borrowers and facilitating the transfer of resources from savers to investors. Banks are also responsible for evaluating who to extend credit to and ensuring that long-term high-return (but risky) projects obtain financing by monitoring borrowers on behalf of lenders.
Today, we take for granted how central banks and the regulatory framework help guide the economy and financial institutions in times of crisis. But any student of economic history knows how a simple stock market crash caused major disaster during the Great Depression in 1929-1933.
The seminal work of this year’s Nobel laureates took shape in the early 1980s. Bernanke showed that the financial disruptions of 1929-1933 reduced the efficiency of the credit allocation process, and that the higher cost and the resulting reduced availability of credit had the effect of depressing aggregate demand, thus leading to the unusual length and depth of the Great Depression. The takeaway was that bank failures can propagate a financial crisis rather than just being the result of the crisis. These findings informed decisions by the Federal Reserve, led by then-Fed Chairman Bernanke, to steer the U.S. financial system and markets everywhere else, and avoid a meltdown in the wake of the Lehman Brothers bankruptcy. which occurred on September 15, 2008.
Dybvig and Diamond developed theoretical models that explain why banks exist, how their role in society makes them vulnerable to rumors of their impending collapse, and how society can mitigate this vulnerability. This knowledge forms the foundation of modern banking regulation and the ecosystem in which a country’s central bank plays a central role in the conduct of financial institutions, especially with the advent of the digital space.
Another area of concern for the Nobel trio has been bank failures which create problems for the rest of the economy, often compounded by the ‘run’ on any bank. A bank run is a situation in which a large number of its customers withdraw their money at once. In a modern banking system, known as a fractional cash reserve system, a bank run can occur due to concerns about bank solvency.
Fractional-reserve banking involves a bank keeping only a portion of the money deposited on the premises. If depositors expect the bank to fail, the ensuing panic can become self-fulfilling. When many consumers withdraw their funds simultaneously, it leads to a severe lack of liquidity and prevents financial institutions from extending loans to borrowers. In the worst case, a bank is pushed into insolvency and fails. An example could be the crisis facing Padma Bank, formerly known as The Farmers Bank, in Bangladesh.
Bank runs are a common feature of extreme crises that have played a prominent role in monetary history. Subsequent research in the 1980s helped show how better regulation can reduce risk and how state intervention can restore stability – albeit at considerable cost to taxpayers. In this context, the example of People’s Leasing and Financial Services, managed by PK Halder, illustrates the risk inherent in unregulated financial services companies that embezzle money after exploiting the trust of the average depositor.
Well, the price announcement was not well received by everyone. David R Henderson of Stanford University’s Hoover Institution mocked the award committee in a the wall street journal op-ed, “Winners have views on managing financial crises that many monetary economists find odd.” Prestigious weekly newspaper Nature said: “Economists win Nobel Prize for showing why banks fail… [their] work explained how finance greases the wheels of capitalism – and why the system is inherently unstable.”
The role of the central bank has evolved over time. A central bank has a universally accepted role: to maintain a stable supply of money. However, it also acts as a regulator of commercial banks. In Bangladesh, as in other countries, the central bank is also responsible for maintaining the exchange rate. In the United States, the Federal Reserve performs five key functions, but the most visible is to regulate the money supply and conduct the country’s monetary policy to promote maximum employment and stable prices.
Two of the most feared lessons of the Great Depression were that a central bank can take an active role in creating liquidity or reducing it. It can also prevent rushes on the banks. Since the last global financial crisis of 2008-2009, we have witnessed significant structural changes in the banking sector. As a report published by the Bank for International Settlements states, “The crisis has exposed substantial weaknesses in the banking system. Technological change, increased non-banking competition and changes in globalization are further environmental challenges. challenges facing the banking system.”
Dr Abdullah Shibli is an economist and works for Change Healthcare, Inc., an information technology company. He is also a Senior Research Fellow at the US-based International Institute for Sustainable Development (ISDI).