In 1661 Johan Palmstruch discovered a Midas touch when he realized that he could solve his bank’s liquidity spread of short-term deposits and long-term loans by issuing credit paper. Dubbed “Palmstruch’s Notes”, they were credited as the first instance of IOUs (“I owe you”) in Europe, backed by nothing but the general public’s confidence in gold coins upon demand. His bank was no longer dependent on having money deposited to be able to lend as new certificates were handed out as loans from the bank. From Dutch spice traders to Italian goldsmiths, everyone wanted to get their hands on the notes promising gold. As banks’ lending rose rapidly and public confidence grew dimmer, the value of Palmstruch’s notes went into a freefall and led to the first bank run in recorded history and nationalization by the Swedish Crown.
In 2022, the Nobel Prize in Economic Sciences was awarded to the research in three dusty papers from the early 80s. In contrast to the Nobel in the hard sciences – which often recognizes a singular, groundbreaking achievement – the prize in economics is more commonly awarded as a testament to an economist’s overall contributions to the field. The award saw a three-way split between Ben Bernanke, Douglas Diamond, and Philip Dybvig for their contributional research on banks and financial crises. The latter two contributed with a model for bank runs which, though brief, has played a pivotal role in modern regulatory policies. Meanwhile, Bernanke’s empirical analysis of the Great Depression has shed light on the destructive power of bank runs during an economic nosedive. Both Diamond and Dybvig are relatively new faces to the general public but have consistently published papers gaining vast influence within the field. Bernanke, on the other hand, is one of the few economists who had the opportunity to put his ideas into action as the 14th Chair of The Fed, battling a combination of reckless lending, lax regulation, and excessive risk-taking during the 2008 Global Financial Crisis. Three papers, taken together, pose three crucial questions:
- What are the essential features of a bank?
- Why are banks the institutions that perform essential functions?
- What happens when the banking system goes sour?”
Leveraging Savings To Fuel Growth
When it comes to financing big-ticket items like houses and cars, we might need a little help financing these purchases. Sure, you might have friendly neighbours or the company you work at willing to lend you their money, but things can get tricky. Households and firms can be uneasy lending out their hard-earned cash. They never know when they might need that money for something else, so they only lend it out if they can get it back right away. That’s where bank’s liquid demand deposit accounts come in: they’re like little insurance policies that guarantee you can get your money back in a flash. The banks take all those demand deposits from different people and bundle them together, turning them into loans. And banks are okay with that since they pocket the difference between borrowers’ high-interest rate and low-interest-bearing demand deposits. The underlying concept that makes it possible is fractional reserve banking; it allows banks to “create money” in which only a fraction of deposits are backed by actual cash and can be withdrawn. While loan generation frees up capital that can be put to better use in the economy, a maturity and liquidity mismatch arises between the bank’s assets and liabilities. This creates an inherent risk of panic-induced withdrawals; no bank has enough reserves to cope with a sudden demand for deposits.
This is precisely what the Diamond-Dybvig model shows. The theoretical model explains maturity transformation, how banks (or any other financial institution that acts like a bank) can provide liquidity to savers while enabling borrowers to access long-term financing. Their key approach is that households possess saved income and may need to withdraw their money at any time, but not necessarily at the same time. Concurrently, there are investment projects that require financing through long-term borrowing. In an economy run without banks, households would need to make direct investments in these projects, creating occasions where households who need to access their money early, must sacrifice returns, leading to lower consumption. Their paper highlights three key ideas:
- Banks help depositors save on the transaction costs
- Bank’s operating structure makes it possible for them to act as intermediaries
- If bank runs inevitably occur, regulation must step in to prevent the suspension of convertibility
The Bernanke Variable
Bank runs were particularly prevalent during the Great Depression in the 1930s when thousands upon thousands rushed into banks demanding their deposits back after hearing rumours about potential insolvency. At the time of Bernanke’s paper (1983), the prevailing theory on the nature of bank runs during the Depression was championed by Friedman and Schwartz (1963). The co-authors saw bank runs impacting the economy only through their effect on the money supply not being expansionary enough to offset the negative effect on bank liabilities. The former Fed Chair, however, proposed that banks play a crucial role in allocating credit in the economy by collecting information about borrowers. Bernanke’s paper shows us that during the Depression, crucial bank-specific information was destroyed, leading to a contraction of credit supply and a prolonged propagation.
Despite the Fed’s approach during the GFC being seen as unpopular and essentially unorthodox, Bernanke’s role as a policymaker was monumental in preventing total collapse. As advanced economies approached a financialization boom, securitization vehicles and money market mutual funds – which, like banks, earn money on maturity transformation – emerged outside the regulated banking sector in the early 2000s. Economists like Paul Krugman warned against “The Dark Side” of banking: excessive leverage used by big players causing systemic risk throughout entire economies. Fast forward to 2008, and it is not just individual customers who are withdrawing funds, but rather institutional investors such as hedge funds or mutual fund managers who may be pulling out billions worth at any given moment at the sight of instability. Since the financing was provided by debt markets in the form of Asset-Backed Commercial Paper (ABCP) and repurchase agreements (repos), reliance on short-term debt made the financial system highly vulnerable. Under Bernanke’s tenure, the FRS stretched the boundaries as far as possible, lowering the interest five-fold within a year and handing out billion-dollar bailouts for troubled assets; it really was a “lender of last resort” move.
Regulating Money Supply
Ever since the concept of fractional reserve banking was first employed in agriculture as the storage of grain and livestock, it has come a long way through a plethora of bank runs and crises to modern times. The banking industry, since its inception, has expanded in scope, complexity, and offerings, becoming the bedrock of economic health. This cobweb-like network is a complex and convoluted behemoth, linking households, businesses, and governments with strands of financial ties and ultimately providing the canals through which money flows and transactions are made.
Today, as central banks around the globe struggle to combat rising inflation, they have turned to the familiar tool of raising interest rates. This means the days of easily accessible, low-cost credit, and expansionary money supply policies may be behind us. The interplay between bank runs, money supply, and interest rates is an ever-evolving dance that requires a delicate balancing act. As the financial world was thrown into turmoil in times of crises or recession, banks were left grappling with a staggering influx of non-performing exposures (NPEs) on their balance sheets. The daunting presence of high interest rates makes it more challenging for borrowers to meet their loan repayments, ultimately leading to an influx of NPEs. While raising interest rates can help curb inflation in the short term, it can also negatively impact economic growth and potentially lead to a recession; there is no one-size-fits-all approach.