Archives for posts with tag: contagion

[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.


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.

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.

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.

“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.]

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.

Ce sondage pose la question à plusieurs grands économistes; doit-on “casser” les grande banques pour rendre leurs problèmes éventuels plus soutenable pour le contribuable et l’économie? Y-a-t-il vraiment un bénéfice net à avoir d’aussi grandes banques?

Sans trop de surprises, la majorité des économistes interrogés répondent qu’il faut casser les grandes banques. Parmi le sous-échantillon d’économistes travaillant sur la banque où ayant publié sur le problème du risque systémique, la réponse est moins claire. Zingales est pour. Hall est contre et commente que les banques feraient alors tout simplement plus appels à des engagements hors-bilan. Goolsbee est indécis et rapelle qu’il y a bien d’autres facteurs de risque que la taille qui ont joué. D’autres réponses sont tout aussi intéressantes, tout comme les réponses à la seconde question.

Mon opinion se situe quelque part entre Duffy qui se dit contre, mais émet le commentaire que la question est intéressante mais requiert davantage de recherche sur les effets pervers de cette mesure, et Levin qui est indécis et demande plus de détails sur les procédures exactes qui seront employés pour réduire la taille des banques.

Il intéressant de noter qu’aucun ne mentionnent d’effets sur la recherche de rente ou la corruption, en se focalisant obstinément sur l’efficience de ces mesures. La façon dont les questions sont formulées y est peut-être pour quelque chose.

Partout on voit les chroniqueurs citer l’article de 1983 de Diamond & Dybvig comme référence sur la ruée bancaire grecque, et maintenant aussi au sujet de l’Espagne. Paul Krugman l’a fait dans le New York Times, mais il n’est pas le seul. Je ne crois pas que ce soit vraiment une bonne référence pour penser aux ruées bancaires en Grèce. En fait j’irais même plus loin dirait qu’il s’agit de ce que Machlup appelait la “concrétude malplacée” (misplaced concreteness) où on cherche des politiques économiques immédiatement applicables dans des modèles qui n’ont rien à voir avec la réalité.

Le modèle de Diamond & Dybvig présente une ruée bancaire un peu particulière, c’est une réaction à une tache solaire (il n’y a aucune cause), les déposants ne peuvent pas réviser leurs anticipations (obligation de pousser la banque jusqu’à l’insolvabilité à chaque fois). C’est un modèle où il n’y a qu’une “banque” avec pour seule fonction de mettre certains risques en commun, elle est donc en fait plus près d’une assurance. Elle ne fait aucun prêt, aucun crédit, n’offre aucun billet de banque et n’a pas de capital. N’est pas modélisé la peur d’une faillite bancaire, ni la “transformation” à proprement parler, mais un problème de liquidité.

Diamond-Dybvig est donc un modèle déterministe, qui est parfois cité de façon pertinente, mais ce n’est pas un modèle vers lequel il faut se tourner à la recherche de solutions concrètes et directes aux problèmes actuels des banques européennes.

Mario Rizzo de l’Université de New York insiste sur un point important concernant l’absence de définition du risque systémique, et la corruption que ce flou génère. Le risque systémique n’a pas de définition claire, pas d’exemple clair, que des scénarios apocalyptiques. Parmi les scénarios sur la table sont ceux de la contagion de contrepartie (les dominos; la faillite d’une institution financière entraînant des pertes plus importantes que le capital des créanciers), et la contagion informationnelle (la faillite révèle des informations sur les risques tiers partagés, et les réactions outrepassent le réajustement et provoquent à elles seules l’insolvabilité d’autres institutions). Aucun n’est vraiment convaincant.

Il est ironique que la crainte du risque systémique ait abouti à accorder plus de pouvoir au Fond de garanti des dépôts américain à travers la Loi Dodd-Frank. Tout suggère pourtant qu’il en est la cause principale, non seulement parce qu’il diminue la quantité de capital des banques ont besoin ou à cause de la façon dont il outrepasse presque toujours son mandat pour assurer tous les créanciers non assurés, ou à cause des techniques utilisées pour résoudre les banques en faillite, mais parce qu’il retarde les faillites. Il en est coupable par une trop grande tolérance réglementaire (une flexibilité qui bien entendu ne comporte pas uniquement des désavantages), mais aussi et surtout parce qu’il empêche l’émergence de ruées bancaires qui pourraient révéler les institutions mal gérées avant le pic de la crise ne frappe, et que les faillites ne soient effectivement plus gérables.

Quel est le rôle de la recherche économique dans l’ensemble de cette situation? Il semble que la plupart du temps elle ait, parfois involontairement, fournie des justifications au fantasme du Too Big to Fail plutôt que l’inverse. Il suffit de penser à la façon dont la contagion financière et les ruées bancaires sont devenues un sujet brûlant au début des années 80, respectivement avec Aharony & Swary et Diamond & Dybvig, pour être utilisé comme une justification pour le renflouement de la Continental Illinois quelques années plus tard. Même chose dans les années 90; Schleifer & Vishny ont fourni un cadre théorique pour que des scénarios apocalyptiques de “fire sale” chez la Long Term Capital Management s’accrochent à nos esprits. Encore une fois, pensez à la façon dont la gestion des liquidités et leur rôle dans les crises est devenu un sujet brûlant dans le milieu des années 2000, et la façon dont la promotion du TARP a été faite… Attention, je ne prétends pas qu’il y ait là une causalité forte, mais le lien est tout de même intéressant.

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