BANKS & FINANCIAL CRISES .

Ben Bernanke, Douglas Diamond & Philip Dybvig laid the foundation of  research in modern banking  in 1980s.Their research is based analysis generated practical solutions  in regulating financial markets & dealing with financial crises. It also explained the banking mechanisms to deal with vulnerability in crises. The research is based on the collapse of banking in 1929 & resultant financial crisis of 1930s. 

Diamond & Dybvig developed theoretical models that explain the societal needs of the bank, their role in society which makes them vulnerable to rumours of their possible collapse, & how society can lessen this vulnerability. These insights form the foundation of modern bank regulation.  

For the regular functioning of  economy it is essential to channelize the savings to the investments. But there is a paradox , depositors in saving accounts  want instant access to their money in case of unexpected situations, while entrepreneurs need to know that they will not be forced to repay their loans prematurely.  

According to Diamond & Dybvig , to provide solution to this problem, bank acts as an intermediary while accepting deposits from many customers & allows access to their money whenever they wish. It also offer long-term loans to borrowers. It also explains how the combination of these two activities results into the spread of rumors of collapse of banks. 

If the large number of depositors wants to withdraw their money simultaneously, the bank may face a real collapse . Banks can save itself from such situations with the help of the deposit insurance provided by the government .The government acts as a lender of the last resort for the banks. 

According to Diamond, when bank acts as an intermediary between saver depositors & borrowers, it allows access to credit only after verifying the creditworthiness & ensures that , the loans are used for good investments. 

Ben Bernanke, illustrated, that the failing of banks had a decisive role in the global depression of the 1930s. He explained the long lasting & deep impact  of the collapse of the banking system. 

This analysis illustrates the importance of effective bank regulation & was also the reasoning behind crucial elements of economic policy during the financial crisis of 2008–2009. 

Before the publication of article by  Bernanke, the conventional concept among economists was that, 'the depression could have been prevented if the US central bank had printed more money'.  Instead, according to Bernanke its main cause was the decline in the banking system’s ability to channel savings into productive investments. 

The depression began with a normal recession in 1929 & till 1930, it turned into a banking crisis. The depositors became worried about the bank’s survival, and rushed to withdraw their savings. Bank’s reserves could not survive the withdrawals & was forced to conduct the sale of assets at potentially huge losses. Ultimately, this may drive the bank into bankruptcy. 

This created fear among all the banks to grant new loans. Instead, deposits were invested in assets that could be sold quickly in case depositors suddenly wanted to withdraw their money. Due to protectionism in credit supply, businesses failed to finance their investments, as well as farmers had to face huge financial hardship. According to Bernanke, when a bank goes bankrupt, the relationship between the bank & its borrowers ends. The bank has detailed information about, the use of borrowed money by borrowers & it has details to ensure the repayment of loan. 

So this  relationship shows the presence of an inherent knowledge capital, which takes a long time to develop this matrix. According to  Bernanke, the economic recovery  did not start until the state adopted powerful measures to prevent additional bank crises.

THE NEED OF BANKS

Banks are differentially perceived by savers & investors. A borrower or a long-term investor must know that the lender will not suddenly demand their money back. On the other hand, a saver(depositor) wants to have a facility to withdraw some of their savings instantly for unexpected outlays.

If companies or households can be forced to repay their loans at any time, long-term investments become impossible. 

DIAMOND & DYBVIG’S MODEL

In an article from 1983, Douglas Diamond & Philip Dybvig develop a theoretical model that explains how banks create liquidity for savers, while borrowers can access long-term financing. 
Despite this model being relatively simple, it simplifies the central mechanisms of banking, including the illustration of vulnerabilities & the need of regulation. The model is based upon households saving some of their income, as well as needing to be able to withdraw their money when they wish.

The need to withdraw money from savings will not be at the same time for every household. Meanwhile, there are investment projects which needs financing. These projects are profitable in the long term, but if they are terminated early, the returns will be very low. 

In such a situation, households will demand a solution that allows them to instantly access their money without this leading to very low returns. Because this solution will be valuable, they will be prepared to accept somewhat lower long-term returns.

THAT’S HOW BANK MAKES MONEY

According to, Diamond & Dybvig, the money in the depositor’s accounts is a liability for the bank, while the bank’s assets consist of loans to long-term projects. The bank’s assets have a long maturity, because it promises borrowers that they will not need to pay back their loans early. 

On the other hand, the bank’s liabilities have a short maturity; depositors can access their money whenever they want. The bank is an intermediary that transforms assets with long maturity into bank accounts with short maturity. This is usually called maturity transformation. Savers can use their deposit accounts for direct payments. The bank has thus created money, from the long-term investment projects to which it has lent money. 

VULNERABLE TO RUMOURS

A rumour ,that more savers than the bank can deal with are about to withdraw their money. Even if it is not true, it can make depositors rushing to withdraw their money. This way a bank may go bankrupt. 

 In order to pay all its depositors, the bank is forced to recover its loans early, leading to long-term investment projects being terminated prematurely and assets being sold in loses. According to Bernanke, the depression in the 1930s is thus a direct consequence of banks’ inherent vulnerability of withdrawal of money by large number of savers.

Diamond & Dybvig recommended a deposit insurance by the government, as a solution to the problem of bank vulnerability. If depositors has guaranteed their money by banks, they no longer need to rush to the bank as soon as rumours start about a bank run.

The existence of a deposit insurance implies that, it never needs to be used. This explains why most countries have now implemented these schemes.

MONITORING OF BORROWERS

Diamond analyses the task of monitoring borrowers to ensure they honour their commitments. 

In reality, most of the investments are risky & returns depends on factors such as general uncertainty & the productivity of the borrower. 

A borrower could try to avoid paying their debts by claiming that an investment failed due to bad luck.  However, even borrowers who have done their jobs well & not wasted any money can sometimes go bankrupt. 

The bank makes an initial credit evaluation & follows the progress in the investment. Without the bank as an intermediary, this type of monitoring would be too difficult or costly. 

Failure in monitoring may risk the commitment of returns by banks to the  depositors & may result in the collapse.  Even if the bank performs its monitoring duties well, it will incur losses on some of its loans. 

However, the risk of collapse due to small credit losses of a major bank will be less, as long as the bank manages its lending activities in a responsible manner. This is because a bank grants loans to a large number of borrowers. Even if a few borrowers default on their loans, the losses across all loans will be small and predictable.

Diamond’s model highlights the significance of banks in the reduction in the cost of  credit intermediation means transferring savings to productive investments. 

If large number of banks fail at the same time, such as during the depression of the 1930s, the process of credit intermediation becomes expensive & resultantly economy stops functioning. Monitoring requires knowledge that dissipates when a bank fails, and this knowledge takes time to recreate.

THE FOUNDATION OF MODERN BANK REGULATION

The work of Bernanke, Dybvig and Diamond has enhanced understanding of banks, bank regulation, banking crises & how financial crises should be managed. 

New financial intermediaries, like shadow banks, earned money on maturity transformation emerged outside the regulated banking sector in the early 2000s. That resulted in the deregulation of large financial sector which became a central theme of the financial crisis of 2008–2009.  Diamond & Dybvig’s theories are effective in analyzing such events however, regulation cannot always work with the rapidly changing nature of the financial system.