Bank runs and resolutions

The collapse of Silicon Valley Bank and the swift intervention by the US authorities hold lessons for India to complete the unfinished policy agenda on handling failed financial firms

- AARTHIKAM CHINTANAM, KP KRISHNAN

The collapse of the Silicon Valley Bank (SVB) and a few other banks has once again drawn attention to the need for better methods and institutions in financial economic policy.

Banks have suffered from runs right from the earliest times. Our thorough understanding of bank runs comes from Douglas W Diamond and Philip HDybvig, who in 1983 obtained deep insights into the fundamental paradox of banking and won the 2022 Nobel prize for this work. Banks are repositories for consumers' cash. The cash in turn is put to use by banks.

However, banks make investments with that cash and generate income, and this tends to tie up money, which cannot be immediately liquidated.

In normal times, this is a good way to create wealth, but it can lead to a crisis if everyone panics and tries to withdraw all their funds at the same time. To quote Professor Diamond "[The system] is very vulnerable to the fear of fear". Banks are intrinsically illiquid, and vulnerable to bank runs, and that itself creates the trigger for bank runs.

Bank runs are very disruptive for ordinary depositors-farmers, pensioners, gig economy workers getting paid through their phones who cannot be expected to understand the fragility of a bank. Governments have a three-pillar path to solving this problem: (1) Prudential regulation tries to cap the risk of bank failure (2) The central bank runs a "lender of the last resort" borrowing window for banks, aiming to lend freely against good collateral and (3) There is a special bankruptcy mechanism for banks that works fast and pays deposit insurance to ordinary depositors.

While many parts of US financial economic policy have deficiencies, most experts hold their system of resolution of bank failure as the gold standard.