Archives for posts with tag: Bank runs

I’ve had three working papers made available on SSRN recently. One is economic history, another one is political economy, and the third one is contract theory. Two of them are related to free banking, and two are related to insolvency. In order of pre-publication:

  1.  Free Banking and Economic Growth in Lower Canada, 1817-1851, with Vincent Geloso

    Generally, the historical literature presents the period from 1817 to 1851 in Lower Canada (modern day Québec) as one of negative economic growth. This period also coincides with the rise of free banking in the colony. In this paper we propose to study the effects of free banking on economic growth using theoretical and empirical validations to study the issue of whether or not economic growth was negative. First of all, using monetary identities, we propose that given the increase in the stock of money and the reduction in the general price level, there must have been a positive rate of economic growth during the period. We also provide complementary evidence drawn from wages that living standards were increasing. It was hence impossible for growth to have been negative. Secondly, we propose that the rise of privately issued paper money under free banking in the colony had the effect of mitigating the problem of the abundance of poor quality coins in circulation which resulted from legal tender legislation. It also had the effect of facilitating credit networks and exchange. We link this conclusion to the emergence of free banking which must have been an important contributing factor. Although we cannot perfectly quantity the effect of free banking on economic growth in Lower Canada, we can be certain that its effect on growth was clearly positive.

  2. Robust Political Economy and the Insolvency Resolution of Large Financial Institutions

    This research applies the robust political economy framework to a comparative institutional analysis of large US financial institutions insolvency procedures. The regimes investigated will be the bailout of financial institutions, Dodd-Frank Act’s Orderly Liquidation Authority, both through procedures that follow original intent and through a ‘bail-in’ route, and 3 bankruptcy possibilities including Chapter 11, a so-called “Chapter 14,” and a mandatory auction mechanism used as a benchmark. We study the robustness of these regimes’ procedures through 5 criteria, both ex ante and ex post. These are the initiation of insolvency procedures, Too-big-to-fail moral hazard, the filtering mechanism, the allocation of resources, and their alleged systemic externalities containment abilities.

  3. In Which Context is the Option Clause Desirable?

    The option clause is a contractual device from free banking experiences meant to prevent banknote redemption duels. It has been used within the Diamond and Dybvig [Douglas W. Diamond and Philip H. Dybvig. 1983. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy 91 (3): 401-419] framework to suggest that very simple contractual solutions can act as an alternative to deposit insurance. This literature has however been ambiguous on whether the option clause can replace deposit insurance outside of those two contexts. It will be argued that the theoretical clause does not generally affect the likelihood that a solvent bank goes bankrupt because of a bank run, as empirical evidence suggests it is already near null, and that the exercise of the clause will have the effect of diminishing the size of creditor claims on bank assets because it exacerbates the agency problem of bank debt. It will therefore be argued that the clause is only desirable in (a) free banking systems that are historically devoid of bank runs in the first place and have other means of managing debt-related agency problems, and (b) under the unrealistic assumption that bank runs are self-fulfilling prophecies. It will be argued that the agency problem of bank debt make the option clause undesirable outside of free banking systems.

There’s more where those came from, I might add another one soon, on bankruptcy theory.

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.

[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.

[T]he mischief takes a wide range. Those who have been accommodated with loans must pay, whatever their readiness or ability to do so. Further advances cannot be obtained. Other banks must call in their loans and refuse to extend credit in order to fortify themselves against the uneasiness and even terror of their own depositors. Confidence is destroyed. Enterprises are stopped. Business is brought to a standstill. Securities are enforced. Property is sacrificed, and disaster spreads from locality to locality. All these incidents of the banking business are matters of common knowledge and experience.

Court of Kansas. 1911. Schaake v. Dolley, 118 p. 80, 83 (Kansas denying a charter to a new bank because “the economy could not support another bank”).

Unfortunately, the decision to close an insolvent bank rests with banking regulators, who do not personally internalize the costs of delay. Regulators who prematurely close a solvent financial institution will offend the shareholders, managers, employees, and depositors of that institution. But regulators who permit an insolvent financial institution to remain open after it should be closed rarely are blamed because the costs of keeping such institutions open are widely dispersed among taxpayers, who must provide the funds necessary to bail out the deposit insurance funds.

Page 1133 of Macey, Johnathan R. and Geoffrey P. Miller. 1993. “Kaye, Scholer, FIRREA, and the Desirability of Early Closure: A View of the Kaye, Scholer Case From the Perspective of Bank Regulatory Policy.” Southern California Law Review 66,  p.1115-1143.

“On the whole, bank runs do not appear to deserve their bad reputation. They did a dirty job in maintaining market discipline–but someone had to do it. Eliminating dirty jobs per se does not eliminate the problems for which the jobs arose.”

Kaufman, George G. 1988. “The Truth About Bank Runs”. In The Financial Services Revolution: Policy Directions for the Future, eds. Catherine England and Thomas Huertas, pp. 9-40. Kluwer and Cato Institute.

The Diamond-Dybvig framework assumes that the bank cannot distinguish between short-term agents that withdraw for effective consumption needs and long-term agents withdrawing because they self-fulfillingly anticipate a run. Mixed with the sequential service constraint, even if the bank invokes a suspension clause there is a risk that short term agents would be at the end of the queue, and seemingly starve to death. How does this assumption hold up in 21st century banking where we have algorithms to instantly detect unusual withdrawals, to protect depositors from fraud? Is it science-fiction to think those algorithms could be calibrated to trigger a variant of the suspension clause on panicky depositors exclusively?

I’m asking because in his 1993 paper George Selgin criticizes the bank suspension as portrayed in Diamond-Dybvig. While so-called “bank holidays” fit the Diamond-Dybvig suspension, some better conceived bank suspension policies were more partial in the sense that depositors could still use their checkbooks and banknotes to consume. They didn’t starve. But bank suspensions might also be more partial in other ways; convertibility might be suspended only for depositors that seem to be in panic. In fact, even thought it was aimed at predatory redemption “duels” rather than Diamond-Dybvig “panic” runs, the option clause of the Scottish free-banking experience was not always used as a blanket measure, applying systematically to all banknotes. In some instances of duels, bona fide customers could still convert their notes while the clause was invoked against other banks’ agents. Granted, it might be easier to tell a regular customer from a competing bank’s employee, than it is to tell apart a customer withdrawing for real needs from a customer that’s panicking, if only because competitors would present a much bigger volume of notes for redemption than your regular customers ever would. But with  nowadays’ technology…?

In this video Larry White of George Mason University covers deposit insurance and bank run literature.

Here’s something I wrote, up for comments. Here’s the abstract:

A 2000 paper by Philippe Aghion, Patrick Bolton, and Mathias Dewatripont off ers a model where what they describe as a free banking system is vulnerable to contagious bank runs through clearinghouse loans. The paper ignores key contributions to both free banking and financial history literature, such that the paper is of little relevance to the understanding of the stability of both free banking systems and clearinghouse arrangements. Our criticism concentrates on the institutions of banking absent or misrepresented. It is argued that it is not clear whether the paper even features banks.

Thirteen years is a very long delay for a comment, but I was not able to find anything addressing this paper, and since it is still cited in almost every literature review on systemic risk, I thought it deserved a comment. Suffice to say, I don’t think think free banking can be dismissed in 6 pages, without giving a proper definition and citing any work on the subject matter.

My usual collaborators in our department seem to be abroad or on vacation this week, so please think of this as a crowdsourced seminar and please do leave a comment.

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.

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