Source: Ideas and Institutions Issue #18
Analysis
US-China tech rivalry will have spillover effects. India must hedge itself
Even as the Indian government is in the process of overhauling its legal framework for regulating technology, the geopolitical environment is becoming complex. On the one hand, the fight over leadership of high-end technology is becoming increasingly contentious and competitive. There is increasing competition for dominance between the US and China that will have spillover effects for countries like India. On the other, countries like India, parts of Africa and regional blocs like the EU are increasingly recognising areas of mutual cooperation, of learning from and adopting scalable and useful technology in cross-border payments, public health systems and e-commerce.
This was originally published in ThePrint on 19 October, 2022.
—By Anirudh Burman
Review
Reading Diamond and Dybvig in India
Economists Douglas W. Diamond and Philip H. Dybvig shared this year’s Nobel Prize with Ben Bernanke. The most seminal work by Diamond and Dybvig is on the economics of banking crises. In this essay, I consider one of their classic papers published in 1983 in the Journal of Political Economy, “Bank Runs, Deposit Insurance, and Liquidity” and reflect upon it in the context of India’s banking system.
Bank deposits are callable at par. Depositors expect them to be returned immediately and fully whenever they make the demand. Bank assets are, however, mostly in the form of loans with long maturity periods (in India, about two-thirds of bank assets are in the form of loans) and only a fraction is in liquid instruments, such as government securities, well-trade corporate bonds, and currency. Banks work in spite of this mismatch between callable deposits and illiquid assets because only a small number of depositors usually withdraw their deposits on any given day. They are also able to make profit by maintaining a spread between the interest they pay to the depositors and the one they charge from borrowers (and the return they make on their holding of securities).
If a large number of depositors go to a bank to withdraw their deposits at the same time, the bank would be unable to meet all the demands because it cannot immediately convert its assets into cash, and if it tries to do so, it would incur losses that may lead to its failure. When do depositors rush to get their deposits from banks? When they perceive the bank to be failing. But the key is that it does not matter whether the bank was indeed failing. Since bank balance sheets are opaque, it is difficult for third parties to be sure about their health at any given time. Once panic spreads, a bank run becomes a self-fulfilling prophecy, making even a previously healthy bank fail in the attempt to meet the depositors’ demands. Faced with such a situation, the only options for a bank are—failure or suspension of withdrawal. Banks often choose the latter.
Diamond and Dybvig begin the paper by observing this problem with banks. Written at the time when the savings and loans crisis was beginning and banking was being deregulated in the U.S., the paper presents an elegant model to understand how banks add value to the economy, why bank runs happen, and what could help avoid them. Their model demonstrated that banks can do better allocation than exchange markets between savers and borrowers by “providing better risk sharing among people who need to consume at different random times.” However, the demand deposit contract providing this improvement has multiple equilibria with different levels of confidence in the bank. One of these equilibria is undesirable—a bank run in which all depositors panic and look to withdraw their deposits immediately, including even those who would prefer to leave their deposits in if they were not concerned about the bank failing. Diamond and Dybvig also show that bank runs cause real economic problems because even "healthy" banks can fail, which has negative effects on the economy. They then go on to show that a deposit insurance mechanism offered by the government or central bank can, in certain circumstances, work better than the alternative—suspension of withdrawals.
Deposit insurance mechanism typically involves payment of a premium by the banks (and eventually by the depositors), recognition of the failure of a bank, and payouts to all eligible depositors. Deposit insurance can reduce the chances of bank runs by assuring the depositors about the safety of their deposits with banks. The main benefit of such a mechanism is to prevent failure of healthy banks on account of bank runs motivated by false information about the bank’s health. Functionally, deposit insurance is similar to the “lender of the last resort” activity that central banks sometimes undertake during crises, when the interbank markets are not able to provide liquidity. Both these mechanisms protect banks that are solvent but are facing a liquidity crisis. Deposit insurance is not free. Even if it is efficiently priced, it creates a moral hazard—the incentive of depositors to exercise prudence while choosing a bank is considerably weakened. So, it should be accompanied by regulatory oversight.
In the paper, Diamond and Dybvig gave elegant explanations for phenomena like banking crises and deposit insurance, which had existed for long. Their achievement was in explaining something that already existed. As Raghuram Rajan noted in a recent tribute to Diamond and Dybvig, a major contribution need not be complicated. It could be simple. Similarly, a major contribution need not propose something new in the world but may offer a better explanation for something that already exists. Most social science research is about explaining phenomena that already exist.
Now, let’s consider India’s banking system. In India, among the scheduled commercial banks, government-owned banks account for about two-thirds in terms of share of bank deposits. These banks run maturity mismatches, but the depositors do not worry about the bank failing. They see these banks as extensions of the government’s balance sheet. The role that Diamond and Dybvig suggest deposit insurance should play is played by the implicit guarantee by the government to save these banks, as the depositors expect government-owned banks to be recapitalized before they fail. This has many consequences.
First, there is a difference between the backstop available to private banks and that available to government banks, which becomes a source of fragility for the former. Deposit insurance covers all banks, but government banks have a stronger backstop—the government’s fiscal resources. So, in a crisis, the depositors having more deposits with private banks than are covered by deposit insurance have an incentive to shift their deposits to public sector banks in search of safety. Viral Acharya and co-authors show this effect in a recent paper. They also argue that this leads to poor resource allocation in the aggregate.
Second, as Urjit Patel has argued, the problem of moral hazard is aggravated in public sector banks due to the enhanced backstop that they enjoy. While deposit insurance creates moral hazard for all except those who place deposits larger than the deposit insurance limit still have an incentive to make a careful choice, with government banks, no such incentive exists as there is no cap on the backstop as such.
Third, since the basic rationale for prudential regulation of banks—assuring the depositors that the bank is healthy—does not really exist for government banks, there is little incentive to allocate regulatory resources to these banks. Regulatory authorities, like all organizations, face resource constraints, which necessitate allocational choices. For the Reserve Bank of India (RBI) as the banking regulator, it does not make sense to give equal priority to regulating government banks and private banks. Further, the special backstop available to government banks also encourages the regulator to delay the recognition of balance sheet problems. Timely recognition of problems and corrective action can prevent bank runs triggered by suspicion of bank failure and help with quick resolution when a bank cannot recover. Neither of these is a factor when it comes to government banks. So, when the problems are eventually recognized, there is some exchange of tough words between the government that foots the recapitalization bill and the RBI, but things again go back to how they were earlier.
Fourth, some inefficiency is created by covering government banks in the deposit insurance mechanism even though they are not expected to use it. Government banks pay premia for deposit insurance. The deposit insurance fund now has about Rs. 1.5 trillion, which is about 1.8 percent of the insured deposits. However, since the deposits with government banks are not expected to use this mechanism, the fund is excessive. This is an inefficient allocation of resources.
A key insight from the Diamond-Dybvig paper is that efficiency gains and crises are two sides of the same coin. Banks improve efficiency of resource allocation by running maturity mismatches, but this can sometimes get them into a crisis. Government interventions should seek to mitigate the latter while doing as little harm to the banks’ contribution as efficient resource allocators as possible. Government ownership of banks obviates bank runs but creates significant distortions in resource allocation done by banks in the economy. So, there may be a silent crisis of inefficiency. It may be better to count on a combination of regulation, resolution, and deposit insurance to ensure safety and soundness in the banking system.
—By Suyash Rai