We Should Listen More to Anna Schwartz

A widely held belief in the United States and the world financial community is that the default of major debtors-whether companies or municipalities or sovereign countries-could lead to bank failures that would precipitate a financial crisis. The remedy proposed by those propagating this view is that major debtors therefore must be rescued from the threat of bankruptcy to avert the projected dire consequences for banks and for the stability of the financial system. I shall argue that (a) a debtor whose affairs have been mismanaged should be liquidated or reorganized under new management; (b) default by major debtors need not result in bank failures; (c) if defaults do result in bank failures, so long as the security of the private sector’s deposits is assured, no financial crisis will ensue. The bugaboo of financial crisis has been created to divert attention from the true remedies that the present financial situation demands.

Schwartz, Anna J. (1987) “Real and Pseudo-Financial Crises,” in Schwartz, Anna J. (ed.) Money in Historical Perspective, University of Chicago Press, p. 271-288.

Contagious Bank Failures: Theory vs. History

Most papers on the random withdrawal theory of bank runs suggest that bank runs are not only self-fulfilling prophecies, that alone is bad enough, but that once the run is motion nothing can stop it. This has serious implications, if bank runs are self-fulfilling prophecies that can’t be stopped then you would expect that there would be a lot of bank failures that are only due to bank runs. You’d expect there would be contagious bank runs. Especially during the National Banking era, which was rife with banking panics. This table suggests otherwise.

Source: p. 183 of U.S. Comptroller of the Currency. Annual Report Vol. 1 1920. Washington, D.C.: U.S. Government Printing Office.

Out of 594 bank failures during the National banking era, only 9 had bank runs as their primary cause. Out of those 9, two were banks closed in anticipation of runs. Out of the remaining 7 bank failures, 6 were eventually restored to solvency by the receivership, so I’m going to assume the losses weren’t that important. Only 4 bank failures out of those 9 occured before the advent of the Federal Reserve, including one case where the bank was closed prior to the run, and the bank that was not restored to solvency by the receivership.

Other bank failures might have been sped up by bank runs, but it was not the primary cause of failure. This means that the run, while certainly costly, might have been salutary and closed down the bank before its managers could enlarge losses. It also suggests that bank runs are, in most cases at least, not self-fulfilling prophecies, and that partial “verification” runs can occur.

So, what this means is that, over the whole National Banking Era, we only have only one potential case of contagious bank run leading to an unsalvable bank failure. I say potential and not definitive, because it might be the case that the failure was, after all, more a result of predation than a result of the bank run. What I mean by that is that it is pretty much always in the interest of other banks, and clearinghouses, to come to the rescue of banks in difficulty, because they can profit from those situations. It wouldn’t be surprising to me that what appears to be the only national bank failure due to contagious bank runs, is actually a case of other banks letting it die so that it can acquire its assets at a discount.

More research is obviously necessary on all of this, especially on the outcome of the receiverships.

Do Banks *Ever* Fail Because of Financial Contagion…?

Source: page 90 of O’Connor, J. F. T. 1938. The Banking Crisis and Recovery under the Roosevelt Administration. Chicago: Callaghan and Co.

Systemic Risk: A Concept in Search of Both a Model and Empirical Evidence

“In economics, as in any empirical science, the advancement of knowledge essentially falls in one of two categories. At times, some noteworthy phenomenon is observed empirically, and we seek plausible models which display the same phenomenon. If our catalogue of models does not contain one that displays the observed phenomenon, then we try to construct models that do. On the other hand, sometimes we find that a particular model in our catalogue displays an unusual or remarkable phenomenon. In this case, we go looking for empirical evidence of that the phenomenon actually occurs in real life.

Systemic risk falls in neither category. We do not have any serious models that can be said to display systemic risk. Thus systemic risk is not a theoretical phenomenon in search of empirical confirmation. Furthermore, we do not have any convincing empirical evidence of phenomenon that can be readily identified as systemic risk. About the only evidence we have for systemic risk is that many central bank officials speak of it when discussing their lender of last resort function or the risk containment measures they impose on private settlement arrangements.”

Jeffrey M. Lacker, Federal Reserve Bank of Richmond, Comments presented at the Second Joint Central Bank Research Conference on Risk Measurement and Systemic Risk at the Bank of Japan, Tokyo, November 16-17, 1998. [Has been edited for brevity and inner consistency.]

Ignoring Economics: Tactics for Beginners and Advanced Practitioners

Reblogged from Pursuit of Truthiness:

President Obama called for an increase in the minimum wage to $9 in last night's State of the Union speech. A lot of economists will take this as a personal affront, wondering how people still think this is a good idea after we explain in every MicroEcon 101 class how it will backfire and result in poor people losing their…

Read more… 323 more words

James' post reflects on a feeling that is common among economists; the weariness of having your discipline's basic insight completely disregarded by policy makers, even though widely agreed upon and taught everywhere. The same anti-intellectual behavior is rightfully looked down upon with regards to environmental and climate studies, yet somehow remains acceptable when it comes to economics. Check out his research on Health Economics.

“both the Spani…

“both the Spanish word ‘empresa‘ and the French and Latin expression ‘entrepreneur‘ derive etymologically from the Latin verb in prehendo-endi-ensum, which means to discover, to see, to perceive, to realize, to attain; and the Latin term in prehensa clearly implies action and means to take, to catch, to seize. In short, empresa is synonymous with action.”

Huerta de Soto, Jesus. 2010. Socialism, Economic Calculation and Entrepreneurship. Cheltenham, UK: Edward Elgar. As quoted in Foss, Nicolai J. and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment. Cambridge, UK: Cambridge University Press.

Misplaced Concreteness: Systemic Risk and Diversification

Research is picking up on what I would call the homogenization theory of systemic risk. Instead of resorting to financial contagion or another propagation mechanism, this theory comes from the realization that bank failures are clustered not so much because failure spills over from banks to banks, but because banks’ balance sheets are relatively homogeneous. If banks invest in similar assets, then it is no wonder that they fail simultaneously, or to a lesser degree, it is no wonder that failure at a first bank triggers a reassessment crisis.

In a Journal of Financial Intermediation article (2010), Wolf Wagner makes the bold claim that it is in fact diversification that makes banks more homogeneous. To understand this claim, take Haldane & May’s example in Nature (2011);

Suppose you have N banks and N distinct, uncorrelated asset classes, each of which has some very small probability, ε, of having its value decline to the extent that a bank holding solely that asset would fail. At the inhomogeneous extreme, assume each bank holds the entirety of one of the N assets: the probability for any one bank to fail is now ε, whereas that for the system is a vastly smaller ε^N. At the opposite, homogeneous extreme, assume all banks are identical, each holding 1/N of every one of the N assets: the probability for any one bank to fail can now be calculated as N^N (ε^N)/N!, and this is obviously also the probability for all N of these banks to fail.

Now, Wagner takes his own version of this example at face value and claims that “diversification also makes the banks more similar to each other by exposing them to the same risks”. The optimal level of diversification, according to Wagner, is actually much lower than the “natural” level of diversification. This makes diversification driven homogenization an interesting market failure.

However, this is obviously only true if you’re completely oblivious to the world’s open-endedness. There is not “N” class of assets that banks can invest in, and the number of classes of assets is ever expanding. The only limit to the classes of assets you’re going to run into is human ingenuity and entrepreneurial spirit. While Wagner formulates no policy recommendation (but others do), this is still a good example of the kind of misplaced concreteness economic modeling is riddled with.

So, if diversification is not responsible for banks’ homogeneity, what is? Jeffrey Friedman and Wladimir Kraus offer in Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation a convincing explanation of why that would be the case. Basel 2 capital rules’ risk weighting of assets created arbitrage possibilities that made mortgage backed securities particularly interesting for banks. Interestingly enough, in Haldane & May’s own words: “Tentative evidence comes from the fact that the world’s five largest banks have shown increasing concentrations of assets over the last ten years, in contrast to the top five hedge funds, whose less concentrated systems can give greater scope for diversity.” This would tend to support Friedman & Kraus; Basel 2/3 regulated banks are more homogeneous  while much more loosely regulated hedge funds are less.