A Relevant Nobel for Our Financially Troubled Times

This year's Nobel prize for economics honours valuable insights into banking

A relevant Nobel for our financially troubled times

This year's Nobel prize in economics honours economists who have provided an explanation for not just how banks work but also why banks require to be regulated. This is a welcome development, not just because of the ongoing economic troubles across the world, but also on account of the claims being made on behalf of cryptocurrency that this new kid on the block would reduce the role of banks.

Let us be clear, Ben Bernanke is not getting the Nobel for the manner in which he regulated the US monetary system during 2006-14 as chairman of the Federal Reserve. There is a difference between carrying out surgery and writing a textbook

like Gray's Anatomy. Bernanke and fellow laureates Douglas Diamond and Philip Dybvig are being honoured for producing the knowledge that allows the textbook to be written, not for skilled action based on that knowledge.

Right Intermediary

The insights generated by the laureates have been built upon subsequently by, among others, Raghuram Rajan, to develop greater clarity on the contours of the regulation, without which the financial sector can undermine the economy itself.

Banks essentially perform three functions: maturity transformation, delegated monitoring and, because of these two, reduction in the cost of capital.

Maturity transformation is what happens when banks take short-maturity deposits from lots of savers and use the savings of the public so accumulated to provide longer-maturity loans, to those who convert savings into investment, that is, use resources to create more value than is embodied in the resources they use. While every depositor is entitled to take her funds back at short notice, because there are many depositors and all their requirements are unlikely to materialise at the same time, banks can make loans for periods longer than the maturity of the deposits. Plus, banks can create money to meet depositors' demands within limits.

Why should the bank serve as an intermediary? Why should savers not give their funds directly to borrowers, as happens in peer-to-peer lending organised by fintech platforms?

Savers would have to incur huge costs to assess the risk inherent in every borrower and in monitoring the use of the borrowed money. They are better off delegating such assessment and monitoring to a financial intermediary. So, banks carry out delegated monitoring, with the expertise they acquire in assessing risk and monitoring project execution, to spare savers the cost of doing this.

(Cyptocurrencies cannot perform this function, even if these can be distributed without the help of banks.) Savers are better off; seekers of capital are better off - they just tap the bank, instead of tapping thousands of savers with different time horizons for their deposits - and the economy makes better use of capital to grow.

If, due to some trigger event, depositors feel their money is no longer safe with their bank, they would all rush to take it out, and this can cause a run on the bank. This is where regulation comes in, by way of deposit insurance, the central bank acting as the lender of last resort and capital buffers.

Diamond and Dybvig provided the rigorous models that explained the logic of

banking. Bernanke's empirical research firmly established two things:

Bank failures were not so much the product of the Great Depression as causal factors.

It was not just the reduction in money stock caused by bank failures but, more significantly, the loss of banking relationships that allowed savings to flow productively to seekers of capital, that caused the economy to sputter and stop.

Credit Where It's Due

When a bank failed, credit supply got squeezed, and, further, the cost of mediating savings to potential borrowers shot up, depressing the demand for credit, especially from smaller enterprises (and households) that do not have access to the bond market.

Now, access to the bond market is a function of high credit rating, achieved through a track record. Advances in information technology and processing can disrupt this model. The consent layer of the India Stack APIs (application programming interface) allows newly licensed account aggregators to consolidate a small company's recent financial activity - including tax payments and input tax credit claims - to present an ongoing, real-time diagnostic report of the borrower's financial health to a creditor.

Superior monitoring technology reduces, in other words, the reputational capital required to tap the bond market. Alongside the pooling of risk by bundling with higher-rated debt, and risk-mitigating derivatives, this would make the public markets a more viable source of credit for small firms, shrinking the exclusive preserve of bank credit.

Understanding how banking works is key to deciding how well they should be capitalised. There is such a thing as too much capital, purely from the perspective of diluting the discipline that depositors exercise, with their ability to stage a run, a restraint capital lacks. Clarity on the working of banking alone can provide regulatory clarity on the distinction between illiquidity and solvency, each calling for a different remedial response.

In a period of global financial stress, the Nobel committee has chosen the right area of insight to honour.

Views expressed are author's own