Why modern banks are inherently unstable: The Tribune India

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Subir Roy


Senior Economic Analyst

THE Nobel Prize in Economics is traditionally awarded to those who have contributed to fundamental economic theory or to those who have redefined theory to explain economic phenomenon in recent times and have highlighted what governments and regulators can do to counter the seizures. This year’s winners fall into the latter category. The award was given to them because the work they do may also be of interest to lay people.

The Swedish Academy, which awards the prize, had said the Nobel Prize went to Ben Bernanke, Douglas Diamond and Philip Dybvig because they significantly improved our understanding of the role of banks in the economy, especially during a financial crisis. And in outlining how to deal with such crises, they also underlined why it is vital to avoid any bank meltdowns during such times. If there are successive bank failures (they tend to have a domino effect) and the economy is plunged into total chaos, it may well lead to a social revolution and the destruction of the authority of the State.

Their work could not be more important than now, when the pandemic broke out in 2020, crippling the global economy. At that time, central banks around the world took significant steps to avert a financial crisis. They were able to do this thanks to the ideas that the work of the three economists produced. This prevented the crisis from turning into a new depression that would have devastated life on the planet.

Now that the pandemic is receding and economic life is slowly returning to normal (India’s economy is expected to grow by around 6% in the current fiscal year), banking regulators could have sat down and resumed business. as per usual. But unfortunately for the world economy, the war in Ukraine has caused huge disruptions in economic life with energy prices soaring and Western European countries, which depend on Russian gas, have collapsed to face a winter of discontent.

As a result, the world is now facing not only high inflation, but also recession. At this point, the ideas offered by the three economists will again be useful in warding off a financial crisis. In fact, the ground may have been prepared for another generation of economists to determine what policy central banks should follow in order to deal with not just one crisis (the pandemic), but two successive ones (the war). from Ukraine).

Bernanke’s research has notably focused on why the modern economy cannot do without banks and, above all, why they seem so fragile, taking little time to become unstable in response to adverse developments. What can be done to improve the stability of the banking system so that banking crises do not last as long as they often do? Perhaps the most heretical thought to emerge from the research is why a failing bank cannot be immediately replaced by a new one so that the economy recovers quickly.

A fundamental mismatch is the main reason why the modern banking system as we know it is so inherently unstable. Savers sometimes want instant access to their money from the bank, but banks have been on-lending savers’ money to businesses that are unable to instantly repay the bank loans their businesses run on.

To understand the phenomenon of modern banking, it is necessary to compare banks with other businesses. If one automaker out of, say, a big five collapses, that won’t negatively affect all the automakers, but, in fact, it may turn out to be a boon because the other four will be able to split the customers of the bankrupt company. company.

Banks are different. Even if a bank is temporarily in a difficult situation and is having trouble paying the checks drawn by its customers, it cannot afford to let its customers know about it. Once it is learned that a bank is struggling to meet its obligations to depositors, all customers who can will line up at the bank to withdraw at least some of their money to meet the requirements. If these customers are unable to withdraw cash, word will spread like wildfire and soon all customers will be lining up to withdraw all their cash deposits.

There will then be a classic race on the bank. Moreover, as soon as there is a run on a bank, the word spreads and there is a good chance that there will be a run on many banks, thus throwing the whole financial system into a crisis.

The whole problem is that the banks lend most of what they receive in the form of deposits to borrowers (mainly companies), who will invest it in their companies and can only hope to recover all that and a little more (profit) after a period of time. This is reflected in the deposit payable ratio of banks, which is typically 5:4, i.e. for every Rs 5 a bank receives, it lends back Rs 4 assuming that many depositors will not want not suddenly withdraw all their five rupees. This is the root cause of the inherent instability plaguing the modern financial system, at the heart of which are banks.

What is the output? One solution is that the banks should be state owned. Once depositors know that the bank is owned by the government, which by definition cannot run out of cash (it can always take out a loan from the central bank by simply issuing an IOU), they will not panic and will follow the herd instinct.

But the world and India are moving away from state ownership. With a large number of private banks, the role of the banking regulator, for us the Reserve Bank of India, becomes really difficult. He must keep his eyes and ears open to know that a bank is in trouble before the public. Once he learns of such a situation, he will negotiate with the bank for a special accommodation if he thinks the bank is inherently sound and only in a temporary situation. But, if it believes that the bank’s business has become inherently precarious (a large borrower who may even be a co-owner has run into financial difficulties), the central bank must take over the troubled bank, turn it around and reprivatize it. If, despite all this, there are aspirants for the governorship of the RBI, it is because they know that if the RBI itself is in a difficult situation, the Union Ministry of Finance, the ultimate boss, will come to his rescue.

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