How bank runs affect economies

The Royal Swedish Academy of Sciences awarded this year’s Nobel Prize for Economics jointly to US economists Ben Bernanke, Douglas Diamond, and Philip Dybvig for their research on banks and financial crises. The academy noted that the laureates had significantly improved our understanding of the role of banks in the economy and why avoiding bank collapses is vital for any economy.

The press release of the academy stated that the body of research on modern banking by the three laureates explained why we must have banks and how bank collapses exacerbate financial crises. The foundations of the research were laid by Ben Bernanke, Douglas Diamond and Philip Dybvig in the early 1980s. Their insights helped countries manage turmoil during the 2008 Global Financial Crisis and the Covid pandemic and avoid a repeat of the Great Depression.

We know that banks act as intermediaries in an economy by accepting deposits and lending them to businesses and households. Banking is a business of trust; depositors put their money in the bank with the assurance that they can withdraw it at any time. Banks keep only a fraction of these deposits as cash or invest in securities, as required by the central bank under the fractional reserve system, and lend the remaining amount to individuals and businesses.

Banks know that only a few depositors withdraw cash at any time. An inherent feature of financial intermediation is maturity transformation, i.e., banks give loans for the long term, funded by short-term liabilities. The very nature of their business makes them vulnerable to rumours leading to bank runs. A bank run happens when most depositors lose trust in the bank and withdraw their deposits, resulting in the collapse of that bank. The problem may be with that bank only.

A systemic bank crisis happens when depositors lose trust in many banks and start withdrawing their deposits, preferring to keep hard cash with them. This is precisely what happened in 2008. Rumours about bank collapses in the US spread to India too, and panicked depositors pulled money from private sector banks. There was a crisis of confidence. In their study, Douglas Diamond of the University of Chicago and Dybvig of Washington University in St. Louis highlighted this.

The duo demonstrated that banks, as intermediaries, are better suited to assessing the creditworthiness of borrowers and ensuring that loans are used for productive purposes, which help in the growth of the economy. Diamond and Dybvig highlighted in their model that bank runs could be prevented if the government provided deposit insurance on bank deposits and acted as a lender of last resort. The insurance on deposits was reassuring and instilled much-needed confidence and trust in the minds of savers.

In India, the Deposit Insurance and Credit Guarantee Corporation (DICGC) guarantees deposits up to Rs 5 lakh. What if banks put in place a system where depositors are permitted to insure their deposits for higher amounts, say Rs 50 lakh, and pay the premium to DICGC? This would soothe the nerves of depositors, while also mitigating bank runs. In India, to prevent a bank run, the RBI steps in to protect the interests of depositors and takes measures like suspending the board, taking over the management of the bank, and putting a cap on how much each customer can withdraw.

Ben Bernanke, former chairman of the Federal Reserve and currently a Brookings Institution economist, examined the 1930s Great Depression, which was unquestionably the worst economic crisis in modern history. He demonstrated how bank collapses were the cause of the Great Depression, and not its effect, as had been thought earlier by economists and policymakers. His findings helped him formulate policies and bail out banks during the financial crisis of 2008 when he was Chairman of the Federal Reserve. As the head of the Fed, he helped major banks like JP Morgan, Morgan Stanley, Citigroup, and Goldman Sachs get funds as part of the government’s bailout programme because they were “too big to fail”.

The critics say, however, that Bernanke failed to see the bubble in the housing market and take corrective measures—why was Lehman Brothers, a well-known investment bank, not bailed out? Bernanke also took several measures, including quantitative easing, which involved the aggressive buying of bonds and mortgage-backed securities to increase liquidity in the US economy. He also slashed the benchmark rates to near zero. Many critics point out that the current inflation is the result of the excess liquidity injected into the economy since 2008.

Criticisms and controversies aside, Ben Bernanke was instrumental in reviving the US economy post-2008 and preventing it from slipping into a depression.

(The writer is a former banker and currently teaches at Manipal Academy of Global Education, Bengaluru)