Archives for posts with tag: Banks

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.

“Practically all the discussion on the relative merits of a centralised monopolistic banking system and a system of competitive banks all possessing equal rights to trade, took a place in a period of some forty to fifty years in the nineteenth century, since when it has never been reopened. In that period, however, the subject was one of the most keenly debated of its time. This is especially true of France, and indeed the period of about twenty years during which French thinkers occupied themselves with this problem is perhaps the most productive of any in French economic literature, both from the point of view of output and from the standpoint of its quality in comparison with that of other countries in the same years.”

Smith, Vera C. (1936) 1990. The Rationale of Central Banking and the Free Banking Alternative. Reprint, Indianapolis: Liberty Fund.

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.

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.

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.

OConnor1938

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

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.

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