Context

The contribution made by this year’s noble laureates in economics has a definitive role to play in the Indian economic landscape, particularly in liquidity creation.

Background

• Douglas Diamond and Philip Dybvig: They have developed theoretical models to explore the banks’ role and why they are/were vulnerable to crises. Their research was motivated by the experience of the banking sector during the great depression (1929-39).
• Ben Bernanke: He addressed the same questions pertaining to the great depression. His work explained why and how the depression became so deep. It also explains how the bank failures at the time destroyed valuable banking relationships and resulted in credit supply contraction leaving scars on the economy.

About

India’s Economic landscape: (before the pandemic)

• Twin balance sheet problem: India has been trying to solve its Twin Balance Sheet problem–overleveraged companies and bad-loan-encumbered banks.
  • The share of large borrowers in the scheduled commercial bank loan portfolio was unusually high at 83.4% pre-covid in 2017.
• Slowdown in overall private investment: Investment witnessed an overall decline; neither the central government nor the private sector shows any appetite for it.
  • At present we can say that the stressed banking sector has accentuated this problem.

India’s Economic landscape: (after the pandemic)

• Recession Alarm Bells: Predictions of deeper recession are on the horizon in many parts of the industrialized West indicating spillover effects on the emerging market including India.
• Strong Dollar surge: The exchange rates are unfavorably affecting the weaker currencies. Indian Rupee too may continue to remain in the shadows of the volatile global economic landscape.

The laureates’ research generated three complementary insights:

1. Valuable “Maturity transformation” is inherently vulnerable(Diamond and Dybvig,1983): In order to create liquidity, the bank transforms long-term borrowing into short-term lending, thereby exposing its depositors to a vulnerability. Concern that other people may demand their deposits back, leading the bank to have insufficient funds, may lead all savers to run to the bank to withdraw their money.
   • Even fundamentally healthy banks may get into trouble if the such bank runs become widespread.
2. Delegated monitoring allows savers to get access to safe, high returns(Diamond, 1984):
3. Delegated monitor is a financial intermediary (bank) because it borrows from small investors (depositors), using unmonitored debt (deposits) to lend to borrowers (whose loans itmonitors). It offers three advantages:
   • It pools funds from many savers and diversifies across borrowers,
   • Banks reduce the aggregate monitoring costs that would otherwise have been borne by borrowers.
   • This enables households’ savings to be channeled to productive investments at a lower cost.

• Jointly, these (1) & (2)“theoretical contributions” explain how financial intermediaries create liquidity in the economy.
• On the liability side, Banks pool many savers (depositors) together, which also enables savers who end up needing liquidity to have their demand met by long-term savers who do not need liquidity at the same moment in time.
• On the asset side, banks pool many loans together and monitor them on behalf of savers, which makes it possible to finance risky and illiquid loans with much less risky and liquid deposits.

4. Financial intermediation is key for real activity(Bernanke, 1983): Banks provide important screening and credit-monitoring services, and they develop crucial long-term relationships with borrowers.

• • During the great depression, it was seen, that when banks failed it took long for the banks to build new relationships, furthering the severe financial crunch.

Present concerns:

• Stressed nature of the banking and finance landscape
• Excessive (public-private) debt accumulation
• Rise of overleveraged companies
• Slowing down growth and production capacity.