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This year's Nobel Prize in economics goes to three American economists, Ben S Bernanke, Douglas W Diamond and Philip H Dybvig for significantly improving “our understanding of the role of banks in the economy, particularly during the financial crisis.”

The Royal Swedish Academy of Sciences reportedly said in a press conference on October 10, 2022, “Modern banking research clarifies why we have banks, how to make them less vulnerable in crisis and how bank collapses exacerbate financial crises. The foundations of this research were laid by Ben Bernanke, Douglas Diamond and Philip Dybvig in the early 1980s. Their analyses have been of great practical importance in regulating financial markets and dealing with financial crises.”

The basic studies were done about four decades ago. But in the meantime, the economic world has changed a lot. Why has the studies received attention so late? The Academy noted, “Later when the pandemic hit in 2020, significant measures were taken to avoid a global crisis. The laureates’ insights played an important role in ensuring these latter crises did not develop into new depressions with devastating consequences for society.”

On the contribution of Bernanke, the Academy observed that the research on banking laid the foundation of some crucial questions on banks. Some of these are, “If banking collapses can cause so much damage, could we manage without banks? Must banks be so unstable and, if so, why? How can society improve the stability of the banking system? Why do the consequences of a banking crisis last so long? And if banks fail, why can’t new ones be immediately established so the economy quickly gets back on its feet?” Moreover, the press release also added, “There is a conflict here: savers want instant access to their money in case of unexpected outlays, while business and homeowners need to know they will not be forced to repay their loans prematurely.” All the relevant issues were discussed by Bernanke by analysing fundamental problems that make banks and money vulnerable and volatile to shocks. Bernanke adequately explained how falling banking played a decisive role in the Great Depression in the 1930s, the worst economic crisis in modern history. In his study, he was able to reveal how the banking system collapses and the downturn is deep and long lasting.

On the contribution of Diamond and Dybvig, the Academy observes, “How the financial markets should be regulated to fulfil their function - channelling savings to productive investments without causing recurring crises.... The researchers being rewarded this year, and the work that builds upon it, makes society much better equipped to take on this challenge.”

In a nutshell

Many experts consider that the previous economic historians had only focused on those banks’ failures as a factor that affected the economy in as much as there was a contraction of  money supply. But Bernanke proved otherwise by uncovering the importance of the credit channel for the propagation of the depression. This led the Academy to recommend him for the Nobel Prize. Diamond and Dybvig came together in 1983 and postulated theoretical works on the role of banking in an economy and what makes them vulnerable to ‘runs’ on their deposits, particularly, at a time of emerging economic crisis when depositors try to withdraw deposits from the banks but the banks are not able to return all the deposits as that is mostly disbursed in long term loans to business communities.

Relevance to Indian economy

India has a long history of bank failures, particularly, before its nationalization in the late 1960s. Even after that, a lot of failed banks were nationalised. In the last few years, a lot of banks had been merged together to form bigger banks. But many banking experts think that it cannot be a solution because the theory of “too big to fail” in the banking system has been proved to be wrong in the global financial crisis of 2008. So rather than consolidation and mergers, strict vigil on banking operations is warranted to pre-empt any mishaps in the financial crisis.