Archives for posts with tag: 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.

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.

I think discussions on plurality of emission deserve a place back in money and banking classes, especially with regards to modern monetary challenges. In this video, Larry White gives a quick introduction to some of the features of free banking systems.

“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.

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.

I’ve noticed a misunderstanding in informal discussions over speed bankruptcy, bail-in, debt-for-capital resolutions (however you might want to call it). There is, on the one side, the Luigi Zingales & Oliver Hart plan (Lucian Bebchuck is mentioned as an inspiration for this plan), and on the other the Mark Flannery / Garret Jones plan. There’s been many different versions of both of these plans and many authors I’m not citing, but for the sake of simplification I’m going to talk about Zingales’ plan and Jones’ plan. Those are the versions I have in mind. While the motivations for both of these schemes are to limit externalities of systemically important financial institutions failures on other banks, these propositions are not the same, they are actually quite different.

Zingales proposes contingent-capital debt contracts that would turn to capital after a pre-insolvency ratio is triggered, with the possibility for shareholders to out-buy these debt holders. I’ve blogged on the difficulty of finding robust pre-insolvency triggers before. Jones’ proposal is akin to a variation on current FDIC’s resolution procedures (and extension of their power to non-bank financial institution). Under Jones’ plan, at the initiation of bankruptcy procedures regulators would forfeit shareholder rights and arbitrarily turn some debt contracts into ownership claims overnight. Zingales’ tries to prevent bankruptcies, while Jones’ tries to limit its costs.

The latest French Banking reform proposal, for example, seems inspired by a version of Jones’ proposal. As my colleagues have argued, it is bound to run into Constitutional challenges; without due process and with limited, ex post, judicial review it is reminiscent of expropriation. Moreover, if the goal is to avoid costly firesales perhaps automatic instant conversion should be used with caution; current regulation makes it complicated and costly for most financial institutions to hold equity in their books. It is difficult to foresee the kind of transactions such bankruptcy resolutions would arouse.

In any case, it is not obvious that speed bankruptcy is necessary in the first place. The literature on the costs of large financial institution failures does not support doomsday scenarios of systemic risk. Studies on the US market suggest that banks are always too diversified to be pushed into insolvency by counterparty losses alone. Research on the much feared bank runs suggest that they aren’t really conducive to systemic risk either. In these episode banks go bankrupt only when they were already insolvent prior to the bank runs. Bank failures are clustered not because of contagion, but because banks invest in the same kind of assets. It is a problem of homogeneity rather than contagion. Also, speed bankruptcy, in both kinds, seems to implicitly take for granted that the current use of assets is always more valuable than any other alternatives out there. That is to say, that a form or reorganization is always preferable to liquidation. This is, at the very best, questionable.

That doesn’t mean there aren’t any good reason why you’d want such a scheme, but they’re not necessarily the ones being put forward. One interpretation of the 1991 FDIC Improvement Act experiment, a law that was thought by the profession to have permanently eliminated Too Big to Fail in the U.S., could be that the checks and limits to bailout powers will always be trampled. A credible, economically viable, alternative to bailouts that would render them redundant would definitely have its place.

Dans la littérature sur les ruées bancaires il y a essentiellement deux visions qui s’opposent. La première, la vision que l’on doit à l’article de Diamond et Dybvig, fait appel à des réactions irrationnelles. Ce sont des “tâches solaires”, ou en d’autres mots des évènements inexplicables ou dont l’explication n’est pas déterminante pour l’analyse. Une des conséquences de traiter les ruées bancaire comme irrationnelles a été que la littérature a mis du temps à reconnaître qu’il pouvait y avoir révision des anticipations, et donc la possibilité que la ruée bancaire soit partielle ou vérificatrice.

La seconde vision, qui n’a pas vraiment d’article fondateur mais qui est assez bien formulée dans l’article de 1986 de Gorton, est celle de la ruée bancaire par la “mauvaise nouvelle”. Les déposants surveillent leur banques à travers des signaux imparfaits, et lorsqu’une mauvaise nouvelle suggère que la banque pourrait ne pas être en mesure de rembourser tous les dépôts, ils courent vers la banque pour y retirer leurs économies.

George G. Kaufman est un des auteur principal de cette seconde vision des ruées bancaires. L’une des conséquences de la rationalité, et du caractère informationnel, des ruées bancaires est qu’elles ne mènent généralement pas à des crises systémiques de large envergure. Les ruées sont généralement confinées aux banques qui partagent le même risque tiers. Les travaux de Kaufman rappellent entre autre que les ruées bancaires n’ont pas que des coûts, mais aussi des bénéfices, et que les banques qui sont bien gérées survivent généralement assez bien aux ruées.

Dans Kaufman, G.G. (1987) “The Truth about Bank Runs,” pp. 9-40 in C. England and T. Huertas (ed.) The Financial Services Revolution. Washington, D.C.: Cato Institute, il offre cettte chansonnette à être chanté sur l’air de “C’est Noël! C’est Noël! C’est Noël!” (Let It Snow! en anglais…);


Oh, the depositors outside are threatening
But our vault is so protecting
And if you pardon the pun
Let them run, let them run, let them run.

Well, they don’t show signs of stopping
So we’re selling assets nonstopping
And until our work is done
Let them run, let them run, let them run.

Now the run is slowly dying
Our cash has stopped the crying
The work has become more fun
Let them run, let them run, let them run.

So, the moral is clearly revealing
If a bank is not concealing
And its capital is like a ton
Let them run, let them run, let them run.

%d bloggers like this: