Why modern banks are inherently unstable

Subir Roy

Senior Economic Analyst

THE Nobel Prize in economics traditionally goes to those who have contributed to the fundamental economic theory or those who have redefined theory to explain the economic phenomenon in recent times and pointed to what governments and regulators can do to counter crises. The recipients this year fall within the latter category. The prize went to them as the work done by them can be of interest to laymen too.

The Swedish Academy, which gives the prize, had said the Nobel went to Ben Bernanke, Douglas Diamond and Philip Dybvig as they significantly improved our understanding of the role of banks in the economy, especially during a financial crisis. And by pointing to the way to deal with such crises, they have also outlined why it is vital to avoid any bank collapse during such times. If there are successive bank collapses (they tend to have a domino effect) and the economy is plunged into utter chaos, it can well lead to a social revolution and the destruction of the state authority.

Their work could not be more significant than in the present juncture when the pandemic broke out in 2020, bringing the global economy to a standstill. At that time, central banks across the world took significant measures to avoid a financial crisis. They were able to do so as a result of the insights that the three economists’ work has produced. This ensured that the crisis did not develop into a new depression that would have devastated life on the planet.

Now that the pandemic is withdrawing and economic life is slowly returning to normal (the Indian economy is projected to grow around 6 per cent in the current financial year), banking regulators could have sat back and returned to business as usual. But unfortunately for the global economy, the war in Ukraine has caused enormous disruption in the economic life with energy prices skyrocketing and countries in Western Europe, which rely on Russian gas, buckling down to face a winter of discontent.

As a result, the world is now staring at not just a high rate of inflation, but a recession too. At this juncture, the insights offered by the three economists will come in handy again to ward off a financial crisis. In fact, the ground may have been prepared for another generation of economists to determine what policy central banks should follow in order to deal with not just one crisis (the pandemic), but two successive (Ukraine war) ones.

Bernanke’s research has, in particular, focused on why the modern economy cannot do without banks and, most importantly, why they seem to be so fragile, taking little time to become unstable in response to some adverse development. What can be done to improve the stability of the banking system so that banking crises do not last so long as they often do? Perhaps, the most heretical thought that emerges out of the research is why a failed bank cannot be immediately replaced by a new one so that the economy picks itself up again quickly.

A basic mismatch is the key reason why the modern banking system as we know it is so inherently unstable. Savers, at times, want instant access to their money with the bank, but the banks have on-lent the savers’ money to businesses that are not in a position to instantly return the bank loans on which their businesses run.

To comprehend the phenomenon of modern banking, it is necessary to compare banks with other businesses. If one car company out of say five large ones collapses, then it will not adversely affect all car companies, but, in fact, can turn out to be a boon as the remaining four will be able to distribute among themselves the customers of the failed company.

Banks are different. Even if a bank is in a temporary tight corner that it finds it difficult to pay the cheques drawn by its customers, it cannot afford to let customers know this. Once the word gets around that a bank is finding it difficult to meet its obligations to depositors, all customers, who can do so, will line up at the bank to withdraw at least a part of their money to meet exigencies. If these customers are unable to draw cash, the news will spread like wildfire and soon all customers will line up to withdraw all their cash deposits.

There will then be a classical run on the bank. What is more, once there is a run on one bank, the word will spread and there is likely to be a run on many banks, thus plunging the entire financial system into a crisis.

The whole problem stems from the fact that banks lend most of what they receive as deposits to borrowers (mostly businesses), who will plough it into their businesses and can only hope to get it all back and a little more (profit) after a period of time. This is reflected in the credit deposit ratio of the banks, which is typically 5:4, i.e. for every Rs 5 that a bank gets, it on-lends Rs 4 on the assumption that many depositors will not suddenly want to withdraw all their five rupees. This is the root cause of the inherent instability that the modern financial system, at the heart of which are the banks, suffers from.

What is the way out? One solution is banks should be state-owned. Once depositors know that the bank is owned by the government, which by definition cannot run out of cash (it can always take a loan from the central bank by simply issuing an IOU), they will not panic and follow the herd instinct.

But the world and India are moving away from the state ownership. With a whole lot of private banks around, the role of the banking regulator, for us the Reserve Bank of India, becomes truly challenging. It has to keep its eyes and ears open so that it comes to know of a bank being in trouble before the public does. Once it comes to know of such a situation, it will negotiate with the bank a special accommodation if it thinks that the bank is intrinsically sound and only in a temporary spot. But, if it feels that the business of the bank has become intrinsically unsound (a large borrower who may even be a part owner has run into financial trouble), the central bank must take over the troubled bank, set it right and reprivatise it. If, despite all this, there are aspirants for the RBI Governor’s job, then it is because they know that if the RBI itself is in a tight corner, the Union Finance Ministry, the ultimate boss, will come to its rescue.

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