Archives for posts with tag: Systemic risk

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.

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[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”…

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.

[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…?

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