Fintechs shadow banks of current time, are fragile: Douglas W Diamond

Professor at the University of Chicago's Booth School of Business, Diamond received the prize along with Philip Dybvig and former Fed chair Ben Bernanke

Douglas W Diamond, winner of the 2022 Nobel Prize in economics, tells Veenu Sandhu and Manojit Saha how banks can brace themselves amidst concerns over a possible recession in 2023; why fintechs, the shadow banks of the current times, are fragile; and what banks can do to inspire greater confidence in their customers. Professor at the University of Chicago’s Booth School of Business, Diamond received the prize along with long-time collaborator Philip H Dybvig and former Federal Reserve chair Ben S Bernanke for having “significantly improved our understanding of the role of banks in the economy, particularly during financial crises”. Edited excerpts:

What are your expectations from the Fed meeting?

Once inflation has gone to the level that it has around the world, it is very important for central banks to do something to get people to expect it to not go up for very long. Otherwise it sort of feeds on itself. People expect more inflation, so they ask for higher prices or wages. Central banks need to worry about that. And the way monetary policy works these days, that means they have to raise interest rates.

I would like to think about the thing that really causes inflation, the real interest rate. So basically, they have to raise the real interest rate above what it was, say, a year ago, when it was like minus 1 per cent or minus 2 per cent. I think the core inflation rate in the United States is 6 per cent or less. So it is not as bad as the one that includes energy prices and all that. So they have to raise it, and that’s just standard matter.

But there is also this issue of financial stability. If people or firms or financial institutions, who/which aren’t necessarily commercial banks, who/which borrow a lot for short-term debt, find that their cost of refinancing or rolling over their short-term debt gets real high, then that could cause financial instability. So the Fed, or central banks anywhere, needs to be measured in how much they do in raising interest rates. They have to be fairly predictable.

Do you think the Fed should increase interest rates aggressively or slow down on the hike?

I think the US has done just fine raising interest rates 75 basis points a meeting. I suspect they can probably do that this time without a problem because the market seems to be pricing that in and expecting it. But at some point when they are pulling liquidity out of the system, which is what raising interest rates does, they could start to cause a crisis. They have to think that they have inflation as their goal, full employment as their goal, but they really have financial stability as their goal. They have got to think about all three. The good news is that particularly after 2008, they think about that.

The global economy is again facing steep challenges and experts are beginning to worry that we might be looking at a recession in 2023. Are there lessons from the 2008 financial crisis that they can draw from?

Because of the 2008 financial crisis, banks, independent of changes in regulations, have already pre-positioned themselves with bigger capital buffers over and above the amount they require as a whole. The recent memory of a crisis gives individual institutions incentives to be a little more careful.

More importantly, regulations have made them hold more capital, which means they have fewer deposits and more equity, so they are a little more secure. In a lot of the world, the commercial banking sector is in a more resilient state than it was. That will prevent a pretty small shark from bringing the system down; obviously a big enough shark can bring it down.

How should banks brace themselves for a possible financial crisis?

I think what they have to do now is if they see we are going into a recession – it may be a small recession; that’s really very hard to predict – they have to raise their credit standards a little bit because the default rate might go up. That by itself might tighten things and make the recession bigger.

Being more careful and having higher lending standards, being more transparent about what their standards are – that’s probably what I would do if I was running a bank, which, thankfully, I am not; I like to be a professor. But that would be what I would do.

Very early in your careers, you and Prof Dybvig wrote a paper on how things can go wrong with banks. You have since spent decades studying the fragility of banks. Does social media play a role in adding to the banks’ vulnerability?

It could. There has not been a good empirical study on that in recent years. There is a paper co-authored by Prof Manju Puri from the Duke University’s Fuqua School that looked at bank runs historically in India. It looked at, sort of, the old-fashioned kind of social network – who talked to whom – to see who was learning that the bank might be having a run and cause them to join the run. She found that was quite important. So that’s a hint that social media could make contagious fear more of a phenomenon that could bring down a bank that had no other reason to go down except the fear of fear itself.

The bank runs we saw recently – in 2008, 2009, 2010 and the ones in the early parts of the Covid crisis – tended to be among institutional investors, big professional investors, and not between people like you and me. They are much less likely to have social media be the thing that’s having them communicate. They’re likely to talk to each other.

The whole point of a run is that you want to get out ahead of the other people. If everybody is doing that, it’s self-fulfilling. If the institutional investors think that other institutional investors think this way, so I better get out ahead of them… People like you and me don’t think like that, so neither one of us has to worry this much.

Are fintechs making banks less relevant? What kind of role and presence do you see banks having in the future?

There are lots of definitions of fintechs. Let me define them in this way: Fintechs are institutions that do a lot of the things that banks do or did, but using a different platform and different technologies to evaluate borrowers and lenders. The paper that Philip Dybvig and I wrote is about whatever be the institution that’s the intermediary between the borrowers and the lenders, it is about the contracts they write. So the Diamond-Dybvig model applies to fintechs just as much as it does to banks. The difference is banks have regulators to keep them from doing too much risky stuff; they have lenders of last resort, the central banks, all over the world.

So, my answer would be more and more of this activity – which is, you borrow short-term and lend long-term – has migrated more and more into these unregulated things like fintechs. So, fintechs have the same fragility that banks used to have, and banks still have to some extent – they don’t have deposit insurance on everything.

I would say fintechs are the shadow banks of the current times. Shadow banks are things that do banking activities without being called banks. So, fintechs, you’ve got to look out for them.

People have said for a long time that now that we have “X”, banks are toast; they’re going to be done. Now they say, now that we have fintechs, there will not be any more banks. That is probably not true. The fundamental thing in society is that there is a profit from borrowing short-term and lending long-term – that’s just there. You make one institution unable to do that, another institution – which Dybvig and I in our second paper called “replacement intermediaries”, now known as shadow banks or fintechs – is just going to move elsewhere. It’s like if you whack one thing down, it pops up someplace else.

The Indian banking sector is dominated by public sector banks. They control about two-thirds of the market share. Do you think this kind of dominance by state-run lenders is healthy? Or is it time the government privatised its banks?

I am, unfortunately, not an expert on the Indian banking system. I will just tell you what I know from evidence around the world – that government banks around the world tend to do more, sort of, politically-connected lending than fundamentals-based lending. That could be a good thing or a bad thing. Like, I lend you money for a bad business – that is definitely a thing about politically-connected banks. The other thing is they could be lending to parts of the economy that need more encouragement or development. That’s the trade-off.

The good news is because they don’t have to totally maximise profit, if the government has a goal, they can allocate capital a little bit. The trouble is there is no way to leave it at a little bit. Once the government or if the government official – even worse – is allocating the capital, you get this sort of crony capitalism.

In terms of the situation in India, I’d have to know a lot more to say anything.

In a country like India where weather plays a critical role in prices, do you think inflation targeting as a framework for monetary policy works? Is it right to make the central bank solely responsible for inflation?

If a central bank wanted to have a goal to ensure inflation and inflation expectations don’t get out of control, the most natural target is actual inflation. Now if you have things that move prices up and prices down – this is not inflation necessarily – you can’t just use today’s inflation, including the goods whose prices move up and down for reasons other than the general excess demand in the economy. So if you have an inflation target in such an economy, you need your own version of core inflation, which is like wages and the prices of these crops that don’t move around so much with the weather. You need to look at what’s called headline inflation and you also need to look at the long-run moving average. You don’t want to look at just today’s inflation. Prices jump, say, 10 per cent; they’re going to go down, say, 12 per cent tomorrow, or if the weather gets better. That’s not inflation. That’s price movements. It is very hard to tell the two apart. So it is harder to have a really good target if you have these things that really depend on the weather.

India, thankfully, is a very well diversified and large economy. If you want central banks to do their job, you have got to give them some kind of a goal. And I think inflation targeting isn’t such a bad one even in India.

So, are you saying instead of targeting the headline inflation, one should look at core inflation for monetary policy?

Yeah, for sure. I don’t personally know how the monetary policy in India is conducted. In the United States, the Eurozone and Japan, core inflation is really the thing that they use. At the US Federal Reserve, there are various measures of the core inflation. They use one that takes account of the fact that if the price of one good goes up, you are going to buy a little less of it, and if the price goes down, you are going to buy a little more of it. So when they weight the different prices, they take account of the fact that when you substitute your spending towards the one whose price went down, that thing gets a little more weight than using the spending you had at the beginning.

When it depends a lot on weather, the central bank had better say: “Well, look, the monsoon was a disaster this year, so we really have to realise prices are going up. We have to communicate to people, ‘That’s not inflation; that’s prices jumping.’”

Coming to the necessity of bank deposit insurance and the need for a government safety net, which you have written about in your paper some 40 years ago. Policymakers across countries have acted on this. What other measures can banks take to inspire greater confidence in customers?

Deposit insurance, particularly if it covers very big fractions of all the deposits out there; if it is big enough for the household deposits that is covers 90 per cent of them, including those who put their substantial wealth into banks; and it covers a big part of the business deposits as well – I think that is important.

You need at least two other things. One, you need confidence-building manoeuvres for the depositors so that they don’t have to worry about banks being in fact insolvent.

There are these things called the stress test where the regulators go and look at the portfolio and use the regulator’s information and the bank’s information to think about what kind of macro-economic or world shocks could bring the bank to an insolvent or close to insolvent position. So, having stress tests that people believe to be credible is very important.

The second is having a bank resolution policy that is not tremendously expensive, so it doesn’t ruin the bank, and is not tremendously punishing of the depositors who sleep at the wheel and leave their money in.

First, you tell the bank to raise more capital, which is more equity. If they can’t do that, then do something like take some of their long-term debt – not their deposits – and write it down from 100 per cent of its value to, say, 50 per cent. That’s a way to force the existing long-term debt-holders to recapitalise the bank. Things like that. So, if a bank gets into trouble, it means the deposits are either insured or would be fine even if they are not insured. That’s the key.

In the post-2008 period, lots of such things were proposed – making it less essential to be the first one out when there is anything wrong with the bank. Those are the second and third lines of defence, after the deposit insurance.