6.1 Introduction

The facilitating role of banks towards promoting and sustaining prosperity in an economy has already been discussed in the preceding chapters. An analogy can be drawn between the banking sector and nuclear plants. Nuclear power has emerged as a formidable alternative to fossil fuels for meeting energy requirements. It has many advantages in terms of proficiency, reliability, ecofriendly aspects and low cost. However, any accident or mishandling in a nuclear plant can potentially cause severe devastation and loss of life. Similarly, the banking sector promotes economic growth in several ways and acts as a critical channel of the MTM to control inflation and mitigate economic fluctuations. At the same time, the banking business entails inherent risks. If the risks embodied in banking are not contained within reasonable prudential limits, they can severely harm the economy.

Any ordinary business involves risks due to fluctuations in sales, production costs, shortage in availability of raw materials, disruptions in the supply chain, employee unrest, deteriorating physical infrastructure, and so on. But the dimensions, configurations and magnitude of risks in the banking business are much wider than those in any non-financial business. Higher risk in banking is mainly explained using underlying bank-specific features such as information asymmetry in and excessive procyclicality of bank lending, scope for bank runs and contagion, and so on. Details of these aspects are discussed in section 6.2.

Ben S. Bernanke, Nobel laureate for economics in 2022, has highlighted how failure of banks can aggravate a conventional economic crisis (Bernanke, 1981, 1983).