Archives for category: Finance

For an Institute for Humane Studies program I wanted to participate in you had to write a short essay on how a famous article or book is misguided and inimical to liberty. I wrote the essay below for the occasion, and I’m pretty happy of how it turned out, so I’m sharing it here. Some readers will instantly recognize the heavy influence of chapter 6 of Lawrence H. White’s Theory of Monetary Institutions—get this book.

The seminal paper by Diamond & Dybvig (1983) on bank runs is misguided and inimical to liberty. It suggests that banks are inherently unstable, always on the verge of suffering a “redemption run” at any unrelated ‘sunspot,’ and that it is absolutely necessary that bank runs be suppressed, and that deposit insurance is the most effective way to do it. In their model, if banks ought to survive it has to be through intervention into the financial system. The basic features of this model are still present in most publications on financial stability to this day.

First, unlike the model would suggest, bank runs are generally not responsible for the initial shock. Gorton (1988) studies the National Banking Era in the US, and finds that for each of the 7 crisis he identifies, bank runs were rather the result of a previous event announcing a possible depreciation of banking assets. Likewise, Calomiris (1991) finds that over 1875–1913 all banking panics (generalized run on all banks) happened within the quarter following an abrupt increase in business failures. Mishkin (1991) studies bank panics from 1857 to 1988, and finds that for all but that of 1873, panics occur well after the recession has started.

Secondly, banks that do go bankrupt because of a bank run are those that are pre-run insolvent. Banks that are solvent can generally borrow from other banks and other institutions, historically clearinghouses, have a large repertoire of possible solutions to help banks is crisis. While bank runs and associated liquidity problems can be aggravating factors, even in the worst bank panic episodes they are causes of bank failure only in exceptional circumstances (Kaufman 1987, 1988). Even in the most fruitful historical era in terms of banking panics and runs, the American National Banking Era, runs were a primary cause of failure in only one case out of 594 bank bankruptcies (Calomiris 1991, 154). Calomiris & Mason (1997) study the banking panic of June 1932 in Chicago and find that no pre-run solvent banks failed. Reviewing this literature, Benston & Kaufman (1995, 225) conclude that “the policy implications of the Diamond & Dybvig (1983) model are not very useful for understanding the workings of the extant banking and payments system.”

A third reason is that most runs have in fact been partial “verification” runs. Depositors eventually figure out that the bank will likely survive the crisis, and runs stop. This is impossible in the Diamond & Dybvig (1983) framework; once initiated the run must always go through and make the bank fail. Ó Gráda & White (2003) study a single bank from the 1850s. They investigate depositor behavior through individual account data, and particularly through the panics of 1854 and 1857. The bank survived both. They find that runs are not sudden, but involve a learning mechanism where random beliefs are progressively dropped, while behavior motivated by legitimate signals become more important over time. Panic does not displace learning in the market processes of bank runs.

Finally, if Diamond & Dybvig (1983) is correct, it should apply to all fractional-reserve banking systems without deposit insurance. But, as evidenced by the US-centric literature cited, bank runs are much more common in U.S. history than elsewhere, and bank panics are specific to the American National Banking Era and attributable to bank regulation of that era, such as the ban on branch banking that made mergers with insolvent banks impossible, and the bond deposit system that limited emission at a critical time (Smith 1991). Bordo (1990, 24) compares bank panics internationally and comments that “the difference in the incidence of panics is striking.” While over the 1870–1933 the US had four panics, there were none in Britain, France, Germany, Sweden, and Canada despite the fact that “in all four countries, the quantitative variables move similarly during severe recessions to those displayed here for the U.S.” Table 2-1 in Schwartz (1988, 38–39) report that from 1790 to 1927 the U.S. experienced 14 panics, while the Britain, the only other country with as many observation, experienced 8, all of them before 1867.

Not only does Diamond & Dybvig (1983) suggest bank runs have much higher costs than evidence does, but it also shrouds its benefits. My research suggests that bank runs could play an important role in initiating insolvency procedures earlier, before the bank can enlarge its losses, and therefore limit systemic externalities.

Apparently because of a bug, all Bitcoin transactions from and to Mt. Gox, one of the biggest and oldest Bitcoin exchange, have been indefinitely suspended. This suspension has caused a drop of 20% in Bitcoin value.

This suspension is interesting, because it highlights one of the drawbacks of a transaction system where base money rather than demandable debt is traded. Indeed, one of Bitcoin’s key feature is a secure, encrypted transaction system. When there is a problem with this transaction system, because it is inseparable from the currency, all transactions must come to a halt. Or, like it is the case here, if one exchange has a glitch all of its transactions must be suspended. This is different from how suspensions, or even so-called ‘bank holidays,’ have worked in the past.

Indeed, in monetary systems where transactions were made in notes, coins or scriptures redeemable in base money by the bank that emitted them, the suspensions were, in a sense, much less painful. These claims could still be traded without affecting the bank that emitted them, though they would sometimes stop being accepted at par, particularly if the bank that emitted them couldn’t participate in the clearing system. This is true if the bank had suspended because of solvency or liquidity issues, but it would also be true in the case of software glitch like it seems to be the case here. There could still be “Bitcoin” transactions through these claims, even though they might be temporarily irredeemable into Bitcoins.

One of Bitcoin’s key feature, an inseparable, secure and encrypted transaction system, can also be a weakness until some form of inside money emerges.

Over at Punto de Vista Economico Nicolas Cachanosky has a very enlightening post on the debate hosted by the Online Library of Liberty about Ludwig von Mises’ Theory of Money and Credit that I posted about earlier. The whole thing is worth reading, as well as Nicolas’ various essays on the topic (here and here for example).

In this post I’m going to go further than I did the last post. I am going to claim that there might actually might be room for a reconciliation in the debate over the convergence to 100-percent reserves in free banking. That is, with a small concession one-hundred-percenteers might be able to salvage the idea that competition among free banks would lead to something close enough to a reserve ratio of 100%. This position was argued by Antoine Gentier in his 2003 book “Economie Bancaire: Essai sur les effets de la concurrence et de la réglementation sur le financement du crédit,” but you might also find it elsewhere in English. A short version of the argument is present in Gentier’s forthcoming paper in English in the JEEH.

He argues that in practice both positions are very close to another, because in the end what matters is not a snapshot or an average of reserve ratios, but the marginal reserve ratio. Indeed, “[p]ast money creation is not the main problem because it has already disrupted the economy by changing relative prices. The main problem relies in the ability of the banking system to create new currency now, and further distort the structure of production.” Over the period studied by Gentier (2003), and myself with Gentier (unpublished), while competing banks’ reserve ratio was very low, their marginal reserve ratio was close to 100%. Because of the phenomenon of adverse clearing, competing banks of issue are incapable of wildly expanding their circulation of banknotes. If they did they would be quickly drained of specie, much like was the case of the Ayr Bank in free banking era Scotland (See White 1995, 27-29). This is something Mises agrees to. It means that free banks could not create credit “out of thin air” like it is sometimes claimed, but had to do it almost entirely through accumulation of prior savings. This is one of the reasons that free banks have very high capitalization levels. At the margin, reserve ratios in free banking would indeed be “up very high and possibly close to 100 percent,” to use the words of Hummel.

White, L. H. 1995. Free Banking in Britain: Theory, Experience, and Debate, 1800-1845. 2nd ed. London: The Institute of Economics A ffairs.

The Online Library of Liberty’s Liberty Matters debate forum just hosted a very interesting discussion on Ludwig von Mises’ Theory of Money and Credit (1912). The lead essay is by Lawrence H. White, with comments by Jörg Guido Hülsmann, Jeffrey Hummel, and George Selgin, and a final reply by White.

It contains, among other things, an enlightening reply by White on Mises’ purported disapproval of free banking, and free banking’s supposed procyclicality. Other topics includes a reassessment of the original contributions of Mises’ book and how his “regression theorem” holds up with the emergence of bitcoins.

This passage in Hummel’s comment was of particular interest to me;

[W]e must carefully distinguish between favoring free banking as a legal regime and predicting how it would operate in practice. I think Larry goes too far when he seems to imply that Mises had in mind the kind of free banking that he (1999) and George (1988) predict would emerge without regulation: that is, a system in which reserve ratios are extremely low and banks adjust the money supply to demand in a way that stabilizes velocity. As much as I may agree with their prediction, I can assure them that Sennholz repeatedly affirmed his belief that unregulated competition among banks would drive reserve ratios up very high and possibly close to 100 percent, and he left the impression that such was Mises’s opinion as well.

Of course Hummel knows that both White’s and Sennholz are equally predictions, and admits his own support for the idea that reserve ratios would be extremely low. But what I want to get to is that Sennholz’s predictions are much less supported than White’s are. They are not equal predictions. This is important because elsewhere one-hundred-percenteers have suggested that the market would favor 100% reserves anyway.  White replies to this passage;

Mises in Human Action (p. 446) does quote Cernuschi to the effect that free banking would have narrowed the use of banknotes considerably, and in other ways suggests that reserve ratios under free banking would be, as Hummel puts it, “up very high and possibly close to 100 percent.” If that is Mises’s prediction, then on this point I do depart from Mises. In my 1992 essay that Hummel cites, I criticized Mises for suggesting that free banking would produce reserve ratios close to 100 percent. The best historical evidence we have, from the Scottish free-banking system and other mature systems, shows reserve ratios below 10 percent.

The historical evidence is one way of answering this. In my own research with Antoine Gentier (unpublished) we found that New England’s freest banking systems in terms of both freedom of entry and banking regulation (ie not in the “Free Banking Laws” sense) had similarly low reserve ratios. But there are also theoretical reasons.

Competition over bank’s financial stability does not only occur over reserve ratios. In our study, for example, banks competed over capitalization levels to prove their resilience. But they could also be competing over the liquidity of their assets, their demand debt to total debt ratio, or a variety of  “living will” arrangements (liability regime of shareholders, option clauses, clearinghouse memberships, etc.) just to name a few. I’m going to conjecture (and derogate from Selgin’s comment on the use of statistics), and say that given the prevalence of banknote circulation as a source of banking profit in free banking systems relative to the costs of these other ways banks can prove their financial stability, it is not at all a blind prediction, or one merely supported by historical anecdotes, to say that reserve ratios would be closer to 1% than they would to 100% under free banking. In fact, it would take a particularly unfree institutional environment for competition between banks to lead to 100% reserve ratios.

[R]ecognition of a state of bankruptcy would have the effect of an atomic bomb. Within a minute, economic agents would try to sell their assets, investors would empty their accounts, foreigners would flee, banks would be forced to close their counters. It’s hard to imagine what state of civil war would be the French and European society.

A bankrupt would have more serious than the Lehman Brothers bankruptcy in September 2008 systemic effects immediately.

Or in the original;

[L]a reconnaissance d’un état de faillite aurait l’effet d’une bombe atomique. Dans la minute, les agents économiques essaieraient de vendre leurs actifs, les épargnants videraient leurs comptes, les étrangers s’enfuiraient, les banques seraient obligées de fermer leurs guichets. On a du mal à imaginer dans quel état de guerre civile serait la société française et européenne.

Un état de faillite aurait immédiatement des effets systémiques plus graves que la faillite de Lehman Brothers en septembre 2008.

Up on Jean-Marc Sylvestre’s blog. It is an interesting (and convenient) theory that the French Government cannot admit of its own financial distress and do something about it because it would trigger systemic risk, when several subsequent rating cuts have not had this effect. Sylvestre’s ideal type can only be a naive investor who’s been living under a rock and bases his investments decisions exclusively on Government announcements. In the real world, though, all empirical studies on flights and runs find that investors are informed and that adverse reactions are rather rational and sophisticated.

I especially appreciate likening flights and runs to atomic bombs and civil wars, all within the same paragraph. John Kay has also used the atom bomb comparison to discuss systemic risk recently. Now, perhaps we should pause and think about the level of sustained economic slowdown that would be necessary to actually destroy capital in a magnitude that is comparable to nuclear explosions or a civil war.

The passage ends with a comparison to Lehman Brothers. Now, this is particularly interesting, because Lehman Brothers did not recognize their own financial distress and tried to push it as far back as they could, willingly failing to prepare for insolvency. It was perfectly understandable, though morally reprehensible, when the worst your financial distress is the bigger are your chances are at securing a bailout. This is one of the principal reason why Lehman’s failure to secure a bailout turned out to be problematic; it had failed to act as diligens paterfamilias and prepare for a wind down. Contrary to the exaggerations in Sylvestre’s column, Lehman Brothers’ experience suggests that “systemic risk,” if there is such a thing, is what happens when recognition of financial distress is pushed back until it cannot be ignored anymore,  much like the French Government is doing.

One justification for the very broad powers of the regulators in the Dodd-Frank Act Title II’s Orderly Liquidation Authority mechanisms is that it would allow the FDIC to act very quickly. This usually means “act very quickly once the process is initiated,” but one key aspect of insolvency resolution is that it also has to be initiated quickly, so as to limit shareholder and manager moral hazard to make things even worse.

Yet, the initiation of insolvency procedures in Dodd-Frank follows from a so-called “three key turning” mechanism. The first key is that the Treasury secretary has to suggest that the firm is “in default or in danger of default,”‘ and have consulted with the President (possibly the fourth key). The second and third key are that two-thirds of the Federal Reserve board, and two-thirds of either the Security and Exchange Commission board for investment banks, two-thirds of the Federal Insurance Office board for insurance companies, or two-thirds of the Federal Deposit Insurance Corporation board must have recommended the initiation of resolution procedures. As should be apparent, this process requires the coordination of multiple agencies, and multiple board members, and is unlikely to be triggered rapidly, if only because of coordination considerations.

Moreover, because initiating insolvency resolution is an admission of failure of prior control, and because the costs of delaying the initiation are essentially shifted onto the FDIC that manages the resolution process, there’s incentives not to recognize the insolvency or to keep hush about it. This was a huge problem for example during the 1980’s Savings & Loans crisis, where insolvent thrifts remained opened for an average period of 17 months before resolutions were initiated, and in a few cases for as much as ten years. The 1993 FDIC Improvement Act sought to fix this problem, by giving the FDIC power to initiate procedures itself, rather than having to rely on the bank’s primary regulator, and by allowing the FDIC to act before the bank is effectively insolvent through what is called “prompt corrective action.” This has, however, obviously not been a success, as in most cases of bank failures during 2008-2009 there were no prompt corrective actions taken, and procedures were initiated after the bank’s equity had dropped in negative territory. This means that, even without rules that require the coordination of multiple agencies with possibly misalligned incentives, regulators’ incentives and knowledge problem generally pushes the initiation of insolvency procedures back.

We actually do have something close enough to a benchmark to see how hard it might be for all “3 keys” to agree and coordinate. The Systemic Risk Exemption of the 1993 FDIC Improvement Act has a similar mechanism, where it required a two-third vote of the FDIC’s board, a two-third vote of the Fed’s Board of Governors, and the Treasury Secretary who has to consult with the President. Triggering this exemption allows the FDIC to bypass the “least cost resolution” provisions of the FDICIA, and allows it to be more generous with its “insurance” fund, providing larger coverage to “uninsured” depositors than is usually the case. It’s essentially an institutionalized bailout procedure.

Despite the fact that it would have allowed the FDIC a lot more flexibility, the Systemic Risk Exemption was triggered only 3 times in nearly 20 years. All 3 cases are recent, as those are Citigroup, Bank of America and Wachovia. In the case of Wachovia, those powers were ultimately not used, as Wells Fargo purchased it instead. This is suggestive that those powers are hard to invoke and use, and might suggest something about triggering the Orderly Liquidation Authority. On the other hand, it is true that the Systemic Risk Exemption could have been triggered much more often under a director that is more bailout-happy than Sheila Bair was (say, Geithner for example).

Given those features of the Orderly Resolution Authority, there’s a chance that initiation might be delayed. Delayed initiation means larger losses, more adverse market reactions, and stronger temptations to bailout, with accompanying calls for further regulation.

Why am I telling you all this? Well, ZeroHedge posted a very revealing figure, detailing the new European Bank Resolution directives and what could be called its “8 key turning mechanism”…

Yesterday I had the honor of participating in the Charles Street Symposium organized by the Legatum Institute in London, under the topic of “What Would Hayek Say Today (Really)?” . The essay I presented is titled “A Hayekian Critique of the New Financial Institutions Insolvency Policies.” Also check out the other essays, they are all exceptional. My coups de coeur are those of Zachary Caceres and Wolf von Laer.

Thus, the right to terminate or close-out financial market contracts is important to the stability of financial market participants in the event of an insolvency and reduces the likelihood that a single insolvency will trigger other insolvencies due to the nondefaulting counterparties’ inability to control their market risk. The right to terminate or close-out protects federally supervised financial institutions, such as insured banks, on an individual basis, and by protecting both supervised and unsupervised market participants, protects the markets from systemic problems of “domino failures.”

Source: Ireland, Oliver. 1999. “Testimony of Oliver Ireland, Associate General Counsel, Board of Governors of the Federal Reserve System, on the proposed Bankruptcy Reform Act of 1999.” Subcommittee on Commercial and Administrative Law, Committee on the Judiciary. U.S. House of Representatives, March 18.

Qualified financial contracts privileges to avoid bankruptcy stay, greatly expanded by a 2005 amendment to bankruptcy laws, were one of the principal source of so-called “disorderly” liquidation during in Fall of 2008, and the main motivation behind most of the 2008 bailouts. It became a primary source of “systemic risk.” See Roe, Mark J. 2011. “Derivatives Market’s Payment Priorities as Financial Crisis Accelerator.” Stanford Law Review 63 (3): 539-590.

File in “systemic risk exaggerations.”

Source: Cihak, Martin, and Erlend Nier. 2009. The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union. IMF Working paper. September.

“Nuclear power and financial systems both have the capacity to blow up the world.”

John Kay’s column in the Financial Times, or up on his blog. I think this might very well be my new favorite systemic risk exaggeration.

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