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Banking On Their Researches

When the Nobel Committee announced on October 10, 2022 that US Economists Ben Shalom Bernanke (b. December 13, 1953), Douglas Warren Diamond (b. October 1953) and Philip Hallen Dybvig (b. May 22, 1955) would receive the 2022 Nobel Prize in Economics, it acknowledged that the world has been going through trying times. The world is on the verge of yet another recession at a time when the US has failed to fully recover from a sub-prime crisis. The COVID-19 Pandemic badly damaged the Global Economy before the Russian invasion of Ukraine made the situation worse. The World Bank (WB), the International Monetary Fund (IMF) and other global lenders have predicted that another recession awaits all, in the near future.

The question arises here: What is the relationship between Recession and the Banking System? As per the conventional idea, a recession would cause the banking system to fail. Economists came to this conclusion after the Great Depression of 1929-33 had triggered a series of bank failures. Bernanke, one of the three Nobel Laureates in Economics this year, analysed vast data and statistics of the Great Depression to show that bank failures were not the outcome of the recession, but one of the causes that had triggered the Depression.

In fact, the Nobel Committee has recognised the research works carried out by Bernanke in the early 1980s. Bernanke’s analysis, based on historical facts, is not a complicated one. He has argued that banks fail due to lack of trust… when people assume that banks cannot return their deposits, they start withdrawing their deposits. And, it is not possible for banks to refund money to all their customers at once, because the money is given to other entities as loan. Therefore, if most of the customers want to withdraw their deposits all at once, then the banks are left with no choice but to close their operations. Failure of one bank gets customers panicked, and as a chain reaction, it gets carried on to operations pertaining to other banks, thus triggering the collapse of the entire banking system.

Bernanke has shown that this fear had led banks to invest deposits in assets that could be easily withdrawn, instead of giving long-term loans, during the Great Depression. As a result, investment (to boost production) declined, and the scenario rocked the GDP of the majority of the European countries. This historical observation was reflected in the 2008 recession, when the Governments had to bail out banks that were in deep trouble. A new phrase – Too big to fail – was coined during that time.

The research works of Diamond and Dybvig, too, are nearly four decades old. The core of their analyses is also straightforward, sans mathematical complexities. The depositors usually want to withdraw their savings from the bank as per their wish. On the other hand, the borrowers would expect the assurance that they will not have to repay the loan before the specified period. The duty of a bank is to maintain a balance between these two. In a nutshell, the job is important because without the existence of banks as intermediary institutions, it would be difficult, as well as expensive, to deposit money or to borrow loans. Diamond and Dybvig also argued strongly in favour of Government guarantees in order to ensure public confidence in the banking system.

By recognising the works of these three economists, the Nobel Committee has reminded the importance of the banking system, and the role of Government during a financial crisis.

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