The Editorial 17 Oct, 2022 - The bigger picture of intermediation, financial crises

17 Oct, 2022

Theme : Economy

Paper : GS - 3


  1. Context
  2. Financial Crises
  3. Risk Factor
  4. Asset-Liability Mismatch
  5. Role of the Credit Market
  6. Deposit Insurance & Credit Guarantee

Context : The  Nobel in economics for 2022 was jointly awarded to Diamond, Dybvig and former U.S. Federal Reserve chairperson Ben S. Bernanke for their “research on banks and financial crises” undertaken in the early 1980s which have formed the foundations of what constitutes most modern banking research. 

Financial Crises : 

  • The Role of the Financial Sector in modern economies and banks are the cornerstone of the financial system. They mobilize savings for investments, create opportunities to pool risks, improve allocative efficiencies, and lower transaction costs when funds exchange hands between borrowers and lenders.
  • Interestingly, the very mechanisms that enable banks to offer these valuable services are also those which, at times, make banks vulnerable to small shocks and market sentiments, triggering a financial crisis and/or bank run with severe consequences.
  • Diamond and Dybvig explain it in their seminal paper on bank runs.

Risk Factor:

  • Take an Example of an ideal situation where banks and firms are honest, banks are healthy with a small volume of non-performing loans, and that the economy is not facing any significant adverse events such as wars, floods, etc. Now, ask yourself if your deposits in a bank are safe under this ideal condition.
  •  According to Diamond and Dybvig, even in this ideal environment banks may fail to meet obligations to depositors due to a different kind of risk — the risk associated with maturity transformation which banks have to undertake to be viable.

Asset-Liability Mismatch :

  • Consider a bank that takes deposits from many small savers. We may face a sudden need for cash due to unforeseen circumstances. Therefore, we prefer to put our savings in liquid deposit accounts from which we can withdraw at minimum notice. On the other hand, the firms that borrow from the bank prefer loans with longer maturity since they want to invest the money in business activities.
  • To make its operation viable, a bank has to pay attention to the needs of both sets of customers. Thus, a bank has to turn short-term deposits into long-term lending. Under ordinary circumstances, a bank’s day-to-day operation remains unaffected by this mismatch of its assets (loans) and liabilities (deposits) because withdrawals by depositors are largely uncorrelated. On a given day, only a fraction of depositors faces an unforeseen need for cash and the need to withdraw money from their accounts.

Role of the Credit Market :

  • During the great depression of the 1930s, nearly 7,000 banks in the United States failed, taking with them $7 billion in depositors’ assets. One can view bank failures at this scale as a consequence of a deep economic downturn and stop there. However, Bernanke in a 1983 paper argued that the disruptions of 1930-33 reduced the effectiveness of the financial sector as a whole by increasing the real costs of intermediating in the market and making credit more expensive and difficult to obtain.
  • Consequently, bank runs played an important role in converting the severe but not unprecedented downturn of 1929-30 into a protracted depression. Bernanke’s research on the banking sector upholds the belief that favorable credit market conditions are essential for moderating shocks.

Deposit Insurance & Credit Guarantee :

  • Deposit Insurance: It is a protection cover against losses accruing to bank deposits if a bank fails financially and has no money to pay its depositors and has to go in for liquidation.
  • Credit Guarantee: It is the guarantee that often provides for a specific remedy to the creditor if his debtor does not return his debt.

FAQs : 

1. What is the Diamond-Dybvig framework ?

Answer : The Diamond-Dybvig framework has been used to explain how financial development affects the rest of the economy and to understand the effects of monetary policy on banks’ portfolio choices.

2. What is Credit Guarantee?

Answer : it is the guarantee that often provides for a specific remedy to the creditor if his debtor does not return his debt.