The Nobel Prize in Economics in 2022 was jointly awarded to Ben S. Bernanke, Douglas W. Diamond, and Philip H. Dybvig for their path breaking work on the role of banks in economic progress by facilitating financial intermediation. The seminal work of these three economists was published mainly in 1983-84. Prior to this, there was no general theory that can convincingly explain the role of banks in the society, especially their role in liquidity creation. Douglas Diamond, and Philip Dybvig present a mathematical model showing that banks act as intermediaries between savers and borrowers. This task, while seems to be simple, is the main driving force of modern economy.
Let's explain the matter in simple terms. Assume a village where the residents have no idea about a formal banking system. Residents have some surplus income (saving) after meeting the necessary expenses from the income they earn. Residents (say savers) are willing to invest the surplus fund (money) in any profitable project. However, the surplus income of a single saver is not enough to invest in a project. Yet, it is possible to invest if everyone's surplus is accumulated together. In this case, the first question comes: who will collect the surplus fund? Let's say that there is an entrepreneur in the village who will collect the surplus income and invest in a project. The entrepreneur's income from the project should be more than the combined investment (principal plus profit). The extra income from the project goes to the entrepreneur, which motivates him to accept the toil of accumulating surplus funds.
However, this simple equation raises many concerns. First, it is important to know who the savers are. Gathering such data is tiresome, time-consuming, and expensive if we compare a village to a country. Second, there is no reason to believe that everyone in the village trusts the entrepreneur with their funds. Many economists have already raised these concerns. Among them Nobel laureate economists including Ronald Coase (1991), Oliver Williamson (2009) and Joseph Stiglitz (2001), and Geroge Akerlof (2001) are notable. But Diamond and Dybvig elaborate on another problem that no one had discussed before in such a persuasive manner. For example, the risk of the project is unknown to the residents. Even if the risk is low, many residents (savers) would be reluctant to take that minimum risk, because most people, in general, are risk-averse. If so, residents do not offer their savings to the entrepreneur. Hence, a profitable project will not be materialised and the economy will suffer, as a result.
Let's say that residents agree to invest in the entrepreneur's project and share the associated risk. In such a case, Douglas Diamond and Philip Dybvig identify another major problem. Most projects are long-term. If a long-term project is to be wound up before maturity, it loses a substantial value. That is, most projects are illiquid in the short run. Since the future is uncertain, a situation may arise in the future in which some of the savers want their fund back before the maturity of the project. In such a case, the entrepreneur will not be able to meet the withdrawal demand. Or if he is forced to meet the demand, the payment will be less than the original amount because of the loss of value for early liquidation of the project. If one of these cases happens in reality, the savers would be reluctant to provide the entrepreneur with the fund. In other words, there is no direct exchange of fund between the saver and the entrepreneur. This is because depositors need assurance of liquidity (get their money back when they require), while investment in projects is an illiquid asset (cannot be converted to money on demand). This mismatch in maturity hinders the flow of funds in the economy.
Douglas Diamond and Philip Dybvig show that bank can solve liquidity problem economically and with more ease than any other agents in society. Banks collect deposits from different categories of depositors. By pooling these deposits, bank provides funds to entrepreneurs for long-term investment. Since collection of bank deposit is an ongoing process, a small number of depositors withdrawing money from the bank at any time does not hurt bank's liquidity position because banks can make-up the withdrawal by selling new deposits. Therefore, bank does not need to ask the entrepreneur to liquidate the project before maturity. However, in some circumstances (such as a mistrust about the banking system, financial crisis domestic or global, worldwide economic collapse, war or any natural disaster) a large number of depositors may rush to the bank counter at the same time to withdraw their funds. Definitely, bank cannot meet the withdrawal demand of a significant number of depositors at the same time. This leads to a liquidity crisis. Douglas Diamond and Philip Dybvig label this situation as 'bank run'.
To avoid a potential bank run, these Nobel laureates call for government intervention either through bailing out the troubled banks directly or through introducing a deposit insurance scheme. These mechanisms will assure depositors that the government will intervene in times of emergency. Douglas Diamond and Philip Dybvig, however, prefer the second option (deposit insurance) to the first (direct bailout). According to them, the central bank as lender of the last resort is not as credible and effective as deposit insurance. If a central bank keeps bailing out troubled banks frequently, bank managers would suffer from moral hazard problem. They may tend to take excessive risks in the hope of higher profits. If successful, the bank will have more profit. If they fail, the government will bail them out. In other words, profit is privatised, and loss is socialised. Hence, central bank's unconditional bailout of distressed banks is not supported. Hence, Douglas Diamond and Philip Dybvig suggest deposit insurance, which is a binding commitment. Penalties can be imposed by holding bank owners, directors and officers accountable for failure.
Needless to say, in the light of this theory, deposit insurance has been introduced in almost all countries of the world. Although there are many criticisms against deposit insurance, there is no better alternative available at the policymaker's disposal to avoid a potential 'bank runs' at this moment. Inspired by this theory, governments in various countries intervened during the Covid-19 pandemic. Expansionary monetary policy to ensure liquidity in the financial sector was widely observed during this time. As a result, financial system did not suffer any disruption in liquidity flow. It implies that the works of these Nobel laureates render important policy implications for the financial world.
Kabir Hassan, Ph.D is Professor, Department of Economics and Finance, University of New Orleans.
[email protected], [email protected]
Mohammad Dulal Miah, Professor of Finance, University of Nizwa, Oman
