Bernanke was, of course, the regulator of the US monetary system as chairman of the Federal Reserve System and the Fed’s Open Market Committee that sets policy rates. His key insight from his study of the Great Depression was that bank failures contributed to, prolonged, and sustained the economic crisis, instead of being one of the many products of the crisis. This informed his decision to provide lots of liquidity, in the wake of the financial crisis that gripped the western world following the subprime crisis and the collapse of investment bank Lehman Brothers in 2008. Bernanke provided big extra dollops of liquidity via extremely low rates and ‘quantitative easing (QE)’, an appropriately opaque name, from a regulatory perspective, for running the dollar printing machines non-stop. With this created money, the Fed recapitalized the banks, by buying their assets off their books — capital adequacy is measured as the ratio of capital to risk-weighted assets, and when you reduce the denominator, you improve the ratio even without adding fresh capital.
You might also like
Why are TCS investors jittery?
The promise and perils of flex fuel vehicles
Railways might ban Oracle if bribe charge is proved
Why this Bengaluru techie shifted 5 homes in 6 years
Conservatives like to blame Bernanke for creating too much money and, thus, creating conditions for inflation that proves difficult to rein in. Some blame him for the misery caused to emerging markets, the so-called Taper Tantrum that followed his statement of intent to start tapering off bond purchases, the instrumentality of QE, in 2013. Why should someone culpable of creating inflationary conditions and emerging market turmoil be rewarded with a Nobel prize, ask critics.
There are two reasons: one, if that ocean of liquidity had not been unleashed, on which all economies eventually floated, there would have been another Great Depression, rather than the Great Recession that materialised; and, more to the point, two, Bernanke is being rewarded for his insights into banking, not for his role as regulator.
Diamond and Dybvig produced a mathematically rigorous explanation for the salience of banks, in terms of their functions of maturity transformation and delegated monitoring of credit utilisation. Maturity transformation is jargon for creating long-term loans out of short-term deposits that depositors can recall at short notice. Delegated monitoring is what banks do, when they vet a loan application for repayment capacity and observe the utilisation of loans to make sure the money borrowed is being put to the use for which the loan had been sanctioned. Because banks perform these two functions, the cost of credit intermediation comes down, for both savers and those who put the savings to generate more money, the investors who take loans. Imagine there were no banks and every saver had to assess the riskiness of every potential borrower before handing over her savings and afterwards, and every seeker of capital had to approach thousands of small savers with small time horizons for lending. The transaction costs of raising even a small loan would be enormous, for both the saver and the borrower.
Now, maturity transformation has an inherent risk: if all savers demand their deposits back at the same time, there would be a run on the bank and it would be unable to liquidate all the assets fast enough or viably enough to meet all the demands. Regulation is the only way out: deposit insurance, a lender of last resort, the central bank performing that role, and buffers of capital. In extreme events, the government can provide the capital, as happened during the financial crisis that began in 2008. Banking is inherently inimical to laisses faire: without a regulator, bank failures would be common, as they, indeed, were, prior to the Great Depression and institution of regulation.
Bernanke did detailed empirical analysis to establish that banking crises sustained and prolonged the Great Depression, rather than the economic crisis causing banks to fail. A banking collapse had two effects: one, which had already been noted by other economists, was to lower the stock of money; two, more importantly, along with the bank went the banking relationships it carried with it, obliterating delegated monitoring, and, thereby, raising the cost of credit intermediation, depressing both the supply of savings and the demand for credit at this higher price.
Understanding the core working of banking also enables better regulation. For example, it is essential to recognise the disciplining effect of deposits — depositors can stage a run on an imprudent bank — whereas bondholders who provide Additional Tier 1 capital cannot. The regulator, therefore, strikes a balance between depending on capital buffers and on discipline by depositors while stipulating the amount of capital the bank should hold.
The world’s major banks are more secure today than they were at the beginning of the 2008 financial crisis, thanks to the regulatory measures that were enforced after the crisis. Yet, it would not do to lower regulatory vigilance as economic stress builds up and the global economy teeters on the edge of recession. The Nobel Prize for banking economics underlines that message.
Elsewhere in Mint
In Opinion, Vivek Kaul writes about a simple question Economics Nobel fails to answer. Rahul Matthan writes on an IT Act change that will enable digital deals in real estate. L. Viswanathan & Anu Tiwari write how a CBDC will help banks and fintech firms reinvent themselves. Long Story explores the curious case of a little-known bank becoming a fintech darling.
