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Understanding Financial Understanding Financial CrisesCrises

Franklin Allen and Douglas Franklin Allen and Douglas GaleGale

Clarendon Lectures in FinanceClarendon Lectures in Finance

June 9-11, 2003June 9-11, 2003

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Lecture 1Lecture 1

Banking CrisesBanking Crises

Franklin AllenFranklin Allen

University of PennsylvaniaUniversity of Pennsylvania

June 9, 2003June 9, 2003

http://finance.wharton.upenn.edu/~allenf/http://finance.wharton.upenn.edu/~allenf/

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IntroductionIntroduction

What happened in Asia in 1997?What happened in Asia in 1997?

Conventional wisdom about causesConventional wisdom about causes Inadequate corporate governanceInadequate corporate governance Lack of transparencyLack of transparency Poor regulatory supervisionPoor regulatory supervision Guarantees by governments and IMFGuarantees by governments and IMF

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ButBut

If these are the explanations why didn’t If these are the explanations why didn’t these crises occur before?these crises occur before? All of these factors were present while the All of these factors were present while the

economies were growing at fast rates for many economies were growing at fast rates for many yearsyears

Crises occur in many situations where Crises occur in many situations where these factors are not presentthese factors are not present

It is necessary to take a broad perspectiveIt is necessary to take a broad perspective

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Banking and Currency Crises in Banking and Currency Crises in the 19the 19thth and Early 20 and Early 20thth

CenturiesCenturies Europe: Crises eliminated by central Europe: Crises eliminated by central

banks in the last half of the 19banks in the last half of the 19thth century century Bank of England: Overend and Gurney crisis in Bank of England: Overend and Gurney crisis in

1866 and Bagehot (1873)1866 and Bagehot (1873)

US: Crises endemic in the last half of the US: Crises endemic in the last half of the 1919thth and early 20 and early 20thth centuries: centuries: Sep 1873, Jun 1884, Nov 1890, May 1893, Oct Sep 1873, Jun 1884, Nov 1890, May 1893, Oct

1896, Oct 1907, Aug 19141896, Oct 1907, Aug 1914

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How do recent crises compare How do recent crises compare with previous crises?with previous crises?

Bordo and Eichengreen (2000):Bordo and Eichengreen (2000):

Gold Standard EraGold Standard Era 1880-19131880-1913

Interwar YearsInterwar Years 1919-19391919-1939

Bretton Woods PeriodBretton Woods Period 1945-19711945-1971

Recent PeriodRecent Period 1973-19981973-1998

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Bordo and Eichengreen’s Bordo and Eichengreen’s (2000) Results(2000) Results

Banking, currency and twin crises have Banking, currency and twin crises have occurred under many different regimesoccurred under many different regimes

Recessions with crises are more severe Recessions with crises are more severe than those without them than those without them

Special features of 1880-1913, 1919-Special features of 1880-1913, 1919-1938, 1945-1971 and 1973-19981938, 1945-1971 and 1973-1998

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IssuesIssues

Why do crises occur unless actively Why do crises occur unless actively prevented by central banks and prevented by central banks and governments?governments?

What policies, if any, are required to What policies, if any, are required to prevent crises?prevent crises?

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Banking Crises: Two Banking Crises: Two TheoriesTheories

1.1. Crises as Financial PanicsCrises as Financial Panics Kindleberger (1978), Diamond and Kindleberger (1978), Diamond and

Dybvig (1983)Dybvig (1983) Multiple equilibriaMultiple equilibria

2.2. Fundamental based crisesFundamental based crises Gorton (1988), Allen and Gale (1998)Gorton (1988), Allen and Gale (1998) Essential equilibriaEssential equilibria

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Crises as Financial PanicsCrises as Financial Panics

Diamond and Dybvig (1983) model: Diamond and Dybvig (1983) model: DDDD

Single good and two riskless assets Single good and two riskless assets

DateDate 00 1 1 22

Short asset y 1 1 1Short asset y 1 1 1

Long asset xLong asset x 1 R>11 R>1r<1Liquidate

1111

ConsumersConsumers Date Date 00 1 1 22

2 ex ante2 ex ante 1 Early 1 1 Early 1 LateLate

identical cidentical c11 c c22

EU=u(cEU=u(c11)+u(c)+u(c22))

Endowment 1Endowment 1

Banks are competitive: Banks are competitive: Maximize EU of depositorsMaximize EU of depositors

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Bank’s problemBank’s problem

MaxMax EU = u(cEU = u(c11) + u(c) + u(c22))

y,x,cy,x,c11,c,c22

subject tosubject to y + x y + x ≤≤ 2 2

cc11 ≤ y ≤ y

cc22 ≤ Rx + y – c ≤ Rx + y – c11

cc11 ≤ c ≤ c22

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Optimal solutionOptimal solution

cc11 = y = y

cc22 = Rx = Rx

u’(cu’(c11)/u’(c)/u’(c22) = R) = R

cc11 < c < c22 since u’’ < 0 since u’’ < 0

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DD: Two “equilibria” at DD: Two “equilibria” at date 1date 1

Good equilibrium implements optimumGood equilibrium implements optimum Early consumers withdraw at date 1Early consumers withdraw at date 1 Late consumers stay until date 2Late consumers stay until date 2

Bad equilibriumBad equilibrium All withdraw at date 1 and cAll withdraw at date 1 and c11=c=c22=(y+rx)/2=(y+rx)/2

Equilibrium selectionEquilibrium selection SunspotsSunspots Lack of common knowledge – Morris and Shin Lack of common knowledge – Morris and Shin

(1998) (1998)

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Policy implicationsPolicy implications

Focus of policy is to rule out the bad Focus of policy is to rule out the bad equilibriumequilibrium

DD suggest that deposit insurance DD suggest that deposit insurance does this at no costdoes this at no cost

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Fundamental Based CrisesFundamental Based Crises

Gorton (1988) found 19Gorton (1988) found 19thth Century US Century US crises are predictablecrises are predictable

Whenever the leading economic Whenever the leading economic indicator represented by the indicator represented by the liabilities of failed businesses liabilities of failed businesses reached a particular threshold a reached a particular threshold a crisis occurred crisis occurred

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Allen and Gale (1998) adapt DD modelAllen and Gale (1998) adapt DD model

Short riskless asset and Short riskless asset and riskyrisky long asset long asset

DateDate 0 0 11 22

Safe asset y 1 1 1Safe asset y 1 1 1

Risky asset x 1 Risky asset x 1 RR>1>1

R R learnedlearned

Now cNow c11((RR) and c) and c22((RR) but otherwise similar) but otherwise similar

to beforeto before

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Optimal allocationOptimal allocation

Benchmark result: Banking crises allow the Benchmark result: Banking crises allow the optimal allocation to be implemented even optimal allocation to be implemented even though deposit contracts are usedthough deposit contracts are used

y/2

c1(R)

c2(R)

D = y

R=y/x

ct(R)

R -

1919

Allen and Gale (2003) show that this Allen and Gale (2003) show that this result holds in a much more general result holds in a much more general modelmodel

With real shocks, optimal risk sharing With real shocks, optimal risk sharing requires contingencies and, given the requires contingencies and, given the debt-like properties of demand debt-like properties of demand deposits, crises are the only way to deposits, crises are the only way to achieve these contingenciesachieve these contingencies

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Costly crisesCostly crises

If banks have superior reinvestment If banks have superior reinvestment possibilities from date 1 to date 2 of possibilities from date 1 to date 2 of ρρ > 1 while individuals can only use the > 1 while individuals can only use the storage technology the optimal storage technology the optimal allocation can be implemented ifallocation can be implemented if Contracts are nominalContracts are nominal The central bank provides money to banks The central bank provides money to banks Resources stay inside the banking systemResources stay inside the banking system

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Optimal allocationOptimal allocation

Risk sharing occurs through variations in Risk sharing occurs through variations in the price levelthe price level

x/2

c1(R)

c2(R)

x

R=ρy/x

ρx/2

ct(R)

R -

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ConclusionsConclusions

Banking crises can beBanking crises can be Financial panicsFinancial panicsOROR Fundamental basedFundamental based

Financial panics can be eliminated with Financial panics can be eliminated with deposit insurancedeposit insurance

Fundamental based crises eliminated by a Fundamental based crises eliminated by a central bank acting as lender of last resort central bank acting as lender of last resort