10 financial crisis-updated lecture slides

8/8/2019 10 Financial Crisis-updated Lecture Slides

http://slidepdf.com/reader/full/10-financial-crisis-updated-lecture-slides 1/99

Dr. V.R. Bencivenga April 13, 2010

FINANCIAL CRISIS AND THE “GREAT RECESSION”

Headlines

Bear Stearns taken over by JPMorgan Chase (March 16, 2008)

Freddie Mac and Fannie Mae seized by Treasury (Sept. 8)

Lehman fails (Sept. 15)

AIG is “nationalized” (Sept. 16, loan of $85 billion, more subsequently)

Reserve Primary “breaks the buck” (Sept. 16)

Bank of America buys Merrill Lynch (Sept. 15), Goldman and Morgan Stanley apply for

bank charters (Sept. 22)

JPMorgan Chase buys WaMu (Sept. 26), Wells Fargo buys Wachovia (Oct. 3)



Government responds

Troubled Asset Relief Program or “TARP,” $700 billion (Oct. 6)

9 largest banks receive capital injections from TARP (Oct. 13)

Fed announces Commercial Paper Funding Facility (Oct. 7, operational Oct. 27) and

Money Market Investor Funding Facility (Oct. 21, operational Nov. 24)

Other Fed “liquidity facilities” (2008-09, closed early 2010)

Citibank and Bank of America get additional support from TARP (Nov. 2008 and Jan.

2009, respectively)

American Recovery and Reinvestment Act or “stimulus package,” $787 billion (Feb. 17)

Fed buys massive quantities of “agency” MBS’s, Freddie and Fannie expand with

government “backing,” other mortgage relief programs



Government has spent hundreds of billions of dollars, and committed trillions of dollars

(TARP, Fed, FDIC, Freddie Mac and Fannie Mae, stimulus package).

The Fed’s balance sheet is more than twice its pre-crisis size.

Freddie Mac and Fannie Mae have supported mortgage markets by guaranteeing hundreds

of billions in mortgages. Fed has bought over a trillion dollars of agency-backed MBS’ s.

Hundreds of billions of spending in the stimulus package.

Timeline of policy responses (FRB NY):

http://www.newyorkfed.org/research/global_economy/policyresponses.html






Topics

What caused the financial crisis?

Bubble

Transmission to the “real” economy

Falling asset prices increase bank leverage (example)

Why allowing undercapitalized banks to keep operating creates risk for the banking system

Fed and monetary policy

Potential for inflation

Fiscal policy

International environment

Government commitments and losses (as of November 2009)

Miscellaneous references

APPENDIX: Diamond-Dybvig model of banks and bank runs



What caused the financial crisis?

The bubble in home prices burst.

Historically, the risk to mortgage lenders had been contained by

(i) due diligence on the borrower’s ability to repay, and on the value of the property.

(ii) substantial down payments by borrowers.

Earlier in the decade of the crisis, there was an erosion of lending standards (“no doc loans,”

“liar loans,” “NINJA loans”, fraudulent appraisals), and reduction of down payments (“no

money down”).

Stage was set for defaults to spike if home prices fell. Lending practices did not screen out

borrowers who couldn’t repay, and high LTV’s (loan-to-value ratio’s) greatly reduced

incentives to repay.



July 3, 2009 WSJ (Stan Liebowitz, UT Dallas), “New Evidence on the Foreclosure

Crisis:”: Argues zero money down, not subprime loans, led to the mortgage

meltdown!



The bubble increased the risk.

As long as home prices kept rising, borrowers who couldn’t repay could simply refinance or

sell (often with a capital gain). This pulled risky borrowers into the pool of applicants.

There were fees and profits to be made, which pulled funds into the mortgage market.

Once the bubble burst, delinquencies/defaults on mortgages rose.



Values of mortgage-backed securities fell.

In the days of “It’s a Wonderful Life,” banks originated and held mortgages. In past decades

(1980’s), securitization was simple (“pass-throughs”).

Securitization: In recent years, investment banks used the cash flows from a pool of

mortgages to manufacture an array of securities (MBS’s) with different risk/return

characteristics (for example, “super-senior tranche,” “mezzanine tranches,” “toxic waste”).

Ratings agencies (Moody’s, S&P, Fitch) rated MBS’s and other “structured products.”

Pension funds, insurance companies, municipalities, banks, Freddie Mac and Fannie Mae,

etc., purchased MBS’s for their balance sheets.

Defaults on mortgages triggered losses on balance sheets of banks (pension funds,

insurance companies, municipalities, etc.).



Losses on MBS’s increased counterparty risk.

MBS’s are difficult to price. You need loan-by-loan information, expertise, and computer

time to price interest rate risk, default risk, and prepayment risk . Banks could not assess the

balance sheets of other banks (and other financial institutions) as home prices fell.

Interbank lending froze.

Many investors in MBS’s used credit default swaps (CDS’s) to insure against potential losses.

AIG, Lehman, MBIA, and Ambac (among others) wrote lots of CDS’s on MBS’s. At its peak,

the estimated notional value of CDS’s was $60 trillion!

Falling values of MBS’s increased probabilities “insurers” would have to make large payouts,

and caused ratings downgrades that triggered higher collateral requirements (AIG). Investors

holding CDS’s had to worry their counterparties would go bankrupt, leaving them exposed to

defaulting MBS’s.

Increased counterparty risk impaired financial firms on both sides of CDS’s.



Losses on MBS’s led to a “ credit crunch.”

Many banks had special investment vehicles (SIV’s, “off balance sheet” entities, not subject

to the capital requirements of banks), with holdings of MBS’s.

When these MBS’s dropped in value, banks took the SIV’s back onto their balance sheets,

which weakened bank balance sheets (beyond the effects of MBS’s banks were already

exposed to).

Banks’ ability to supply credit to the economy was impaired.



Money market mutual funds held debt of financial firms (including banks) with exposure to

falling home prices and commercial real estate prices. Reserve Primary “broke the buck” (it

held Lehman debt). Run on MMMF’ s!

MMMF’s are major purchasers of commercial paper issued by firms for working capital.

MMMF’s had to increase liquidity due to redemptions, and therefore lending to firms in the

CP market fell. (Fed set up lending facilities to alleviate the credit crunch—see below.)

Commercial paper market seized up. Spreads on corporate debt spiked. Credit crunch.



These mechanisms are self-reinforcing.

(1) Spatial correlation of home prices. In an area with a high delinquency/default rate,

foreclosures push home prices down further. More borrowers are pushed under water,

increasing the default rate and foreclosures.

(2) A common need to deleverage. When financial firms (“banks”) experience big losses on

their balance sheets, they need to sell/write down their distressed assets, reduce their

liabilities, and rebuild their capital cushions (“shrink their balanc e sheets,” i.e., deleverage).

Losses drive banks’ share prices down, making it harder to raise additional capital.

Selling distressed assets drives down their prices, especially if lots of banks are trying to

sell simultaneously. Why? Distressed MBS’s are difficult to price, so they become

illiquid . “Lemons problem!” The further asset prices fall, the more must be sold to

rebuild capital.



Risk associated with MBS’s was increased by these self -reinforcing mechanisms.

This risk spread throughout the financial system due to interdependence of financial firms

(borrowing/lending, CDS’s, etc.), and “mark -to-market” accounting.

Potential for such an increase in risk had not been anticipated correctly. Systemic risk. Too

big to fail, too interconnected to fail.



Bubble

Why did money flow into mortgages? (Supply of funds.)

o Freddie Mac/Fannie Mae

i. implicit government backing of Freddie and Fannie reduced their cost of funds

ii. Freddie and Fannie faced political pressure to increase availability of mortgages

and to serve previously underserved borrowers

o Securitization (argued to reduce risk, spread risk)

o Ratings agencies (interpreted as a government “stamp of approval”)

o Global glut of saving, US current account deficit (US was exporting financial

intermediary services)

o Low interest rates (causing investors to seek yield)

o Higher yields on MBS’s (as lending standards eroded)

o Boom in home prices (MBS’s made profits!)

Why had home prices boomed? Money flowed into mortgages!



Why did demand for mortgages increase? (Demand for funds.)

o Low interest rates (global glut of saving, Fed policy)

o Freddie Mac/Fannie Mae (lower cost of funds allowed lower mortgage interest rates)

o Lending standards eroded (people with weak credit viewed a mortgage as a one-way

bet)

o Boom in home prices (homeowners decided to save through their homes, homeowners

took equity out of their homes, investors bought homes to “flip” them)

Why had home prices boomed? Growth in demand for home ownership—and mortgages!

Economists have various concepts for a “bubble.” It is difficult to model bubbles!



Wall Street Journal, April 6, 2009



Transmission to the “real” economy

Impaired banks and financial markets

o Uncertainty about values of MBS’s. Illiquidity of MBS’s in secondary market. Difficult to

deleverage and clean up balance sheets.

o Losses on bank balance sheets due to declining values of MBS’s and related derivatives.

Potential insolvency. Difficult to raise capital and clean up balance sheets.

o Fear of additional losses on bank balance sheets. Counterparty risk due to unknown

sizes and locations of losses on balance sheets throughout the financial system. Retreat

to extremely cautious lending practices.

o Higher demand for safe assets such as Treasuries, and correspondingly lower demand

for corporate debt, commercial paper, etc. Credit crunch.

o Shrinking “shadow” banking system (hedge funds, MMMF’s, etc.). Extreme decline in

non-bank lending.



Wealth effects

o Equity in homes decreased more than $6 trillion at the low point (summer 2009 in many

areas, prices still falling in some areas)

o Losses of stock market wealth about $6 trillion (low was early in 2009)

Consumption expenditure fell as households increased saving (consumption-smoothing in

response to wealth shocks and higher future taxes)

Investment spending fell (lower levels of expenditure reduced profitability of investment)



Falling asset prices increase bank leverage and impair banks’ capacity to make loans

Let’s illustrate this with a simple example. To begin, all banks are identical.

BANK #1

A L

Cash 10 100 Deposits

Loan to BANK #4 5 5 Borrowed from BANK #2


Common risky asset 80

Unique risky asset 30 20 Equity = A – L

Leverage = A/E = 6.5

Equity (net worth, capital) is what the bank is worth to its owners.



Bank #1 experiences a shock to its balance sheet:

Unique risky asset held by Bank #1 is wiped out.

Bank #1 is insolvent and is shut down:

Defaults on its loan from Bank #2.

“Calls” its loan to Bank #4.

During liquidation, Bank #1’s holdings of the common risky asset are sold, driving

the market price down from 80 to 75.

Mark-to-market accounting. Bank #4 sells assets to pay off its loan from Bank #1.

Both banks are now more highly leveraged! Leverage = A/E

Banks #2 and #4 must “shrink their balance sheets” (deleverage). How? Reduce

assets and liabilities. (Or raise more capital, i.e., boost denominator.)



BANK #1

A L





Unique risky asset 30 20 Equity = A – L

BANK #1

A L


Loan to BANK #4 5 5 Borrowed from BANK #2 Loan to BANK #5 5 5 Borrowed from BANK #3


Unique risky asset 0 30 20 0 Equity

In shutting down Bank #1, the common risky asset is sold, driving its price down to 75.



BANK #2

A L


Loan to BANK #1 0 5 5 Borrowed from BANK #7


Common risky asset 75 80 20 10 Equity

Unique risky asset 30 Assets/Equity ↑ from 130/20 = 6.5 to 120/10 = 12

BANK #4

A L


Loan to BANK #9 5 5 Borrowed from BANK #1 “called” Loan to BANK #10 5 5 Borrowed from BANK #11

Common risky asset 75 80 20 15 Equity

Unique risky asset 30 Assets/Equity ↑ from 130/20 = 6.5 to 120/15 = 8

Both banks are now more highly leveraged, and must shrink their balance sheets!



How can these banks deleverage?

Sell assets, and use the proceeds to retire liabilities.

Raise capital (sell an equity stake in the firm).

“Almost i nsolvent” means a bank is highly leveraged, so a relatively small further drop in

asset prices would wipe out equity.

If the bank is close to insolvency, an investor who buys an equity stake faces a lot of risk.

Situation facing banks with exposure to MBS’s of uncertain value.

If assets are illiquid, deleveraging by selling assets can be difficult or impossible.

MBS’s became very illiquid, due to their uncertain value and the “lemons problem.”



Summary

When leverage ratios spike due to asset prices dropping, it can be difficult for banks to

deleverage and clean up their balance sheets.

Until they do, banks’ lending is likely to be reduced!

The more widespread are balance sheet problems, the more difficult deleveraging tends to

be!

“Fire sales” of illiquid assets drive asset prices down (mark-to-market accounting).

No one wants to invest in almost-insolvent banks!



Why allowing undercapitalized banks to keep operating creates risk for the banking system

Bank balance sheet and bank capital

Assets Liabilities

Reserves Deposits

Loans to/deposits in other banks Borrowing/deposits from other banks

Government bonds

Risky assets (corporate bonds,

credit card debt, commercial real

estate, home equity loans,

mortgage loans, MBS’s, etc.)

Equity = Assets – Liabilities

Bank capital is what the bank is worth to its owners. If the bank has stockholders, the

fundamental determinant of the bank’s stock price is the bank’s net worth.



Market capitalization vs balance sheet accounting

If there were no uncertainty about the values of a bank’s assets and liabilities, the bank’s

market capitalization (total market value of the bank’s stock) would equal the bank’s net

worth as stated on its balance sheet.

In reality there is great uncertainty about these values, since they represent claims to receive

and obligations to make future flows of payments.

Present values of these flows are uncertain because of various risks, such as inflation risk,interest rate risk, and default risk. Therefore, the stock market may value a bank differently

from the value derived from balance sheet accounting.



Financial intermediation

Banks channel funds from savers to borrowers. How can this process create value, in an

economic sense? Banks

evaluate investment opportunities

screen borrowers, and offer loan contract(s) appropriate to the mix of borrowers in the

applicant pool (mix of creditworthiness of applicants)

monitor borrowers and investments, which conserves on monitoring costs compared to

individual savers having to monitor (“delegated monitoring”)



Asset transformation

Other financial intermediaries perform one or more of the same functions as banks (such as

private equity companies). Among financial intermediaries, what makes a bank?

A bank gathers funds by issuing liabilities (deposits). A bank uses these funds to buy assets

(reserves, loans to other banks, government bonds, and various other risky assets, such as

corporate bonds, credit card debt, home equity loans, mortgages, MBS’s, etc.).

Bank liabilities are relatively liquid, and bank assets are relatively illiquid.

“Checkable” bank deposits can be used as a means of payment (a depositor can write a

check). “Demand deposits” can be converted to cash, on demand, at face value (one dollar

of deposits converts to one dollar of cash). These kinds of bank deposits are very liquid.

Except for reserves, bank assets are relatively illiquid, and some, such as mortgages andMBS’s, are quite illiquid.

Thus, banks transform illiquid assets into liquid liabilities.



Risks to depositors

How can a bank issue liquid liabilities, even though most of its assets are less liquid, and

some are quite illiquid?

What if lots of depositors suddenly decide to withdraw their deposits—won’t the rest of

depositors end up with less, or have to wait for illiquid assets to be sold? What if the risky

assets fall in value, and assets no longer cover liabilities?



Two main reasons banks are able to engage in asset transformation:

1) A bank relies on the “law of large numbers” to predict the fraction of its deposits it

should keep as reserves in order to meet withdrawal demand.

While a bank can’t predict when any one depositor will make a cash withdrawal, it can

forecast the average amount of withdrawals with great accuracy.

But if depositors believe other depositors are going to “run” on the bank, there will be

a run, and depositors’ funds would be at risk, because illiquid assets can only be sold

at a loss.



2) Banks maintain a cushion of capital (equity).

If the value of a bank’s risky assets falls, the loss reduces equity, and the bank can meet

its liabilities.

But if the loss is enough to more than wipe out equity, making the bank insolvent,

depositors’ funds are at risk .

Furthermore, near-insolvency, combined with the limited liability of the owners of the

bank, is conducive to excessive risk-taking by banks (leveraged financial firms).

We will now discuss the second of these two sources of risks to depositors. (A very

interesting and useful model of the first is the Diamond-Dybvig model —see appendix.)



Leverage

Consider a situation where a bank has the following balance sheet (simplified):

Assets LiabilitiesReserves 5 Deposits 100

Loans 110

Net worth (capital) 15

Suppose some loans turn out to be non-performing (these could be MBS’s or other assets).

Specifically, the value of loans falls by 10. Depositors must be paid, according to the deposit

contract offered by the bank (priority among creditors). The entire reduction in the value of

assets is absorbed by capital. Bank’s balance sheet is now:

Assets Liabilities

Reserves 5 Deposits 100

Loans 100 110

Net worth (capital) 5 15



Value of assets changes by -8.7%=115

115-105. Value of capital changes by -66.7%=

15

15-5!

Value of bank capital responds proportionally more to a change in value of bank assets,

because the bank is leveraged.

Bank’s owners do not use only their own funds to engage in lending, but borrow

additional funds from others (depositors, and other lenders to the bank).

The owners (stockholders) are the residual claimants, so the entire impact of

fluctuations in the value of the bank’s assets falls on capital. Owners “own” the upside,

if assets gain in value, and also the downside!

Leverage = assets/equity

After the reduction in the value of its loans, its leverage ratio increased from 115/15 = 7.7 to

105/5 = 21. At this new, higher leverage ratio, it would only take a 5/105 = 4.8% additional

reduction in the value of its assets to wipe out shareholder equity completely.



Excessive risk-taking

Highly leveraged financial firms can be prone to excessive risk-taking.

To see why, regard the two balance sheets as describing two different banks. The first bankis adequately capitalized. The bank that suffered a loss to its asset values is under-

capitalized.

Suppose a risky investment opportunity comes up for both of these banks.

Invest 15. With probability 50%, gross return of 30. With probability 50%, lose theinvestment.

Expected net return is zero! A risk-neutral investor would be indifferent between

making this risky investment and not making it. A risk-averse investor definitely would

not make it.

Bank can undertake this risky investment by selling some of their loans.

Here are the balance sheets of the banks if they purchase the risky asset, and after the risky

asset pays off. Each balance sheet has two possible outcomes depending on whether the

investment succeeds or fails.



Balance sheet of the adequately capitalized bank

Assets Liabilities

Reserves 5 Deposits 100Loans 95

Payoff from risky asset 30 with prob 50%

0 with prob 50% Net worth (capital) 30 with prob 50%

0 with prob 50%

Balance sheet of the under-capitalized bank

Assets Liabilities

Reserves 5 Deposits 100

Loans 85

Payoff from risky asset 30 with prob 50%

0 with prob 50%

Net worth (capital) 20 with prob 50%

-10 with prob 50%



Adequately-capitalized bank:

From the perspective of the owners, the expected net return from the risky investment is

zero. With probability 50%, capital increases by 15 (from 15 to 30), and with probability 50%,

it falls by 15 (from 15 to 0).



Under-capitalized bank:

Owners of the under-capitalized bank have a very different view of the situation! If the

investment fails, the bank’s net worth becomes negative.

At that point, the owners can walk away, because of limited liability. They don’t have to

come up with 10 in order to allow the bank to meet its obligations to its depositors. Instead,

either depositors will lose 10 of their deposits, or, if the deposits are insured, the FDIC will

pay out 10.

Expected net return to the owners of the under-capitalized bank is ( ) ( ) 5=505.+5205. -- .

Bank’s capital was 5 to begin, and it either increases by 15 (to 20), or it goes to 0 (falls by 5)—

since it can’t “go negative.” The owners of the undercapitalized bank want to proceed with

the investment!

Obviously, the incentive to undertake excessive risk is a problem for depositors, or possiblyfor the government, if bank deposits are insured by an agency such as the FDIC.



Moral hazard

The incentive to undertake excessive risk is an example of a moral hazard problem facing

depositors (and government regulators).

A moral hazard problem arises when an “agent” (bank owners/managers) has incentives that

are not aligned with the interests of a “principal” (depositors).

Because of leverage and limited liability, bank owners/managers have the incentive to place

depositors’ funds in investments that are riskier than depositors want to be exposed to!

“H eads I win, tails you lose! ”

Limited liability is a feature of most forms of ownership. Allows owners to walk away from

their businesses if the value of the business becomes negative.

Limited liability has social value because it encourages entrepreneurship. But it also

encourages the kind of risk-taking that we see in this example, by shielding owners fromdownside risk when they do not have enough equity in the firm.



Past and possible future regulatory responses

Capital requirements. Some financial firms (including banks) are subject to regulations

that specify minimum capital requirements and maximum leverage ratios.

Risk adjusted capital. Some regulations (Basel II) make the minimum amount of capital

a bank must hold a function of the riskiness of its assets (“risk-adjusted” capital).

Procyclical capital requirements. Leverage ratios of banks are correlated with economic

conditions. Proposals are being considered to discourage banks from becoming too

highly leveraged in good times (and to not require drastic “deleveraging” in bad times).

Convertible debt: Banks could be required to issue special bonds that automatically

convert to equity if certain trigger events occur (negative shocks to the bank or the

financial system).



Higher capital requirements for big, systemically-important banks. Another proposal is

to increase capital requirements for banks (or other financial firms) that are deemed to

be “too big to fail.”

The logic is that when banks become too highly leveraged, they create systemic risk.

A large, leveraged bank makes decisions based on the risk to its own capital, not taking

into account the costs to the financial system (and the tax-payers) of insolvency.

A possible regulatory response would be to allow banks to become big, but to force

them to internalize the externalities that their size confers on the financial system, bymaking capital requirements a function of size.

Banks pay fees to create a fund to be used to rescue banks in a crisis.

Others.



Summary

When bank assets fall in value, putting banks close to insolvency, regulators must take

action.

Otherwise, banks owners/managers may undertake excessively risky investments—which are

not in the interests of depositors or the FDIC, and may exacerbate systemic risk, potentially

at taxpayers’ expense.

During fall 2008 and winter 2009, as losses on bank balance sheets mounted, alternative

possible regulatory actions were debated:

nationalizing the banking system (perhaps following a “good bank,” “bad bank” model

to resolve the nationalized system)

capitalizing the banks (using TARP funds, resulting in government stakes in banks—

TARP funds mostly repaid by 2010)

using TARP funds to get bad assets off bank balance sheets (reverse auctions)



Monetary policy

Fed responded to the economic crisis in three ways:

1. Traditional monetary policy —Fed’s target interest rate, Fed funds rate, was lowered

quickly, basically to zero.

2. Lending facilities were invented, to allow banks to “park” or “pawn” illiquid assets at

the Fed, in exchange for reserves, and to allow funds to flow back into parts of financial

markets that had dried up.

3. Purchased more than a trillion dollars of agency-backed MBS’s, to encourage mortgage

lending, and to hold down mortgage interest rates (more than half of SOMA holdings).

http://www.newyorkfed.org/markets/soma/sysopen_accholdings.html






Target Federal funds ratehttp://www.federalreserve.gov/monetarypolicy/default.htm

2008

December 16 ... 75 - 100 0 - 0.25

October 29 ... 50 1

October 8 ... 50 1.5

April 30 ... 25 2.00

March 18 ... 75 2.25

January 30 ... 50 3.00January 22 ... 75 3.50

2007

December 11 ... 25 4.25

October 31 ... 25 4.50

September 18 ... 50 4.75

Summer 2007 was when several hedge funds failed, and there were signs of financial

market turmoil. From June 2006 to September 2007, the target Fed funds rate was 5.25%.

http://www.federalreserve.gov/monetarypolicy/default.htm


http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm#2653










2004

December 14 25 ... 2.25

November 10 25 ... 2.00

September 21 25 ... 1.75

August 10 25 ... 1.50

June 30 25 ... 1.25

2003

June 25 ... 25 1.00

2002

November 6 ... 50 1.25

The Fed cut interest rates after the 2001 recession, and 9/11.



http://www.federalreserve.gov/monetarypolicy/fomchistorical2003.htm












2001

December 11 ... 25 1.75

November 6 ... 50 2.00

October 2 ... 50 2.50

September 17 ... 50 3.00

August 21 ... 25 3.50

June 27 ... 25 3.75

May 15 ... 50 4.00April 18 ... 50 4.50

March 20 ... 50 5.00

January 31 ... 50 5.50

January 3 ... 50 6.00

2000

May 16 50 ... 6.50

March 21 25 ... 6.00

February 2 25 ... 5.75










Fed lending facilities

http://www.newyorkfed.org/markets/openmarket.html

Central bank liquidity swaps: Swap lines are set up with central banks. When a CB draws on

its swap line, the Fed sells dollars to the CB at the market ER in exchange for the CB’s local

currency. Simultaneously, the Fed and the CB sign a contract saying the CB will buy back its

local currency at the same ER (i.e., the second transaction undoes the first). Durations range

from overnight to three months.

Lending to depository institutions: Discount window borrowing, Term Auction Facility (Dec.

2007, winding down). All loans are fully collateralized with the value of the collateral

exceeding the size of the loan by an appropriate amount (“haircut”).

Lending to primary dealers: Primary Dealer Credit Facility, Securities Lending (loans of

government bonds and agency securities), Term Securities Lending Facility, Term SecuritiesLending Options Program. Collateralized.





Other lending facilities:

Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

A facility that makes loans to banks so they can buy high-quality asset-backed

commercial paper (ABCP) from money market mutual funds (MMMF’s). Goal is to help

MMMF’s meet redemption demand, and to enhance liquidity in the market for ABCP.

Collateralized loans, non-recourse.

Commercial Paper Funding Facility

Fed loans money to an SPV, which buys 3-month unsecured and asset-backed

commercial paper from issuers. Loans are collateralized. MMMF’s purchases of CP

dropped in fall 2008; volume of CP fell, interest rates spiked. A large share of CP is

issued by banks, directly or indirectly, and when banks can’t sell CP, they can’t supply

credit to the economy. The CPFF ensures that issuers of CP can roll over their CP whenit matures, thereby reducing the risk to investors of buying CP.



Money Market Investor Funding Facility

The MMIFF makes senior secured loans to private-sector SPV’s, which purchase CD’s

and CP from money market mutual funds. 10% of the purchase price is ABCP issued by

the SPV, and 90% is borrowed from the MMIFF. Assets purchased under the MMIFF are

CD’s and CP issued by highly-rated financial institutions, with remaining maturities of 7

to 90 days. The goal is to allow MMMF’s to extend the terms of their loans without

jeopardizing liquidity. The MMIFF was established because MMMF’s were increasing

their liquidity levels in response to redemptions, and the goal was to restore the

capacity of MMMF’s to engage in longer-term lending.

Term Asset-Backed Securities Loan Facility

The TALF makes loans to owners of asset-backed securities. The goal is to promote

ABS’s backed by consumer and business loans (student loans, auto loans, credit card

loans, loans guaranteed by the Small Business Association), and to improve the

functioning of the ABS market. Loans are collateralized, non-recourse loans; “haircuts”

ensure the borrower absorbs initial losses, and the TARP is protecting the NY Fed

against the next $20 billion of losses.



Fed’s balance sheet and the potential for US inflation

Starting at the beginning of 2008, Fed greatly increased its “purchases” of various assets

(through open market operations and various lending facilities).

Up to Sept. 2008, Fed sterilized these purchases (Fed paid for these purchases with reserves,

then withdrew these reserves via open market sales of Treasuries).

“Buying” the assets with reserves increased reserves.

Selling Treasuries decreased reserves (since Treasuries had to be paid for with reserves).

Starting Oct. 2008, Fed’s balance sheet exploded (Fed “prints money”). Composition is

structured to target interest rates on select assets classes.

“Credit easing” (Fed’s version of Japan’s “quantitative easing”).



Fed's Balance Sheet, Assets

0

500

1,000

1,500

2,000

2,500

Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

$

b i l l i o n s

CPFFAMLF

Maiden Lane II & IIIAIGMaiden LanePDCFForeign currenciesTAFDiscount windowRPsSecurities, lent

Securities, not lent



Fed's Balance Sheet, liabilities

0

500

1,000

1,500

2,000

2,500

Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

$

b i l l i o n s

Treasury, supplementary

Treasury, generalBank reserves

Reverse RPs

Currency



0

400

800

1,200

1,600

Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

$

b i l l i o n s

Bank reserves

Currency



Note:

Before Sept 2008, Fed’s holdings of Treasuries was falling (sterilization).

After Sept 2008, lending facilities grew, and the size of the Fed’s balance sheet exploded

(from about $700 billion, to about $2.2 trillion).

Lending facilities grew until about March/April 2009, then they contracted.

About March 2009, the Fed started buying agency-backed MBS’s. As of April 2010,

agency MBS’s account for about half of Fed assets!

Lending facilities have essentially disappeared!



While the Fed’s holdings of unconventional assets were large, the size of the Fed’s balance

sheet caused great worry about inflation. Explain.

Bernanke argued the expansion of the Fed’s balance sheet would not cause inflation:

o Fed could “unwind” most of its liquidity facility positions quite quickly and

straightforwardly—most positions were self-terminating, and the rest could be sold.

Proved to be correct — positions are now very small (April 2010). o Fed now pays interest on reserves—increasing this interest rate should put a “floor”

under short-term interest rates, since banks won’t lend at a lower rate.

o Fed has mechanisms to “soak up” excess reserves (reserve term deposits, which don’t

count as bank reserves, and “ reverse repos” ).



Does that mean we should not be worried about inflation at this point?

Reason for concern about future inflation does not derive from the Fed’s balance sheet, but

rather from the projected future size of government debt.

An independent Fed will not deliberately cause inflation in order to reduce the real value of

the debt. But if legislation weakens the independence of the Fed, a political decision to

default via inflation could be taken. Explain.



Allocation:

1. Capital purchases

$225 billion (capital injections into banks, etc.)

$70 billion (AIG)

$45 billion (additional support for BofA and Citi)

2. Financial assistance to automakers and related industries

$85 billion

3. Public-private investment program (PPIP)

$30 billion

4. Grants to mortgage servicers and other programs to mitigate foreclosures

$50 billion (HAMP)

5. Remaining TARP funds

$200 billion



Allocation and projections of profits/losses, by CBO:

1. Capital purchases

$225 billion (banks, etc.) – $1 billion (basically even!)

$70 billion (AIG) $36 billion

$45 billion (BofA and Citi) – $5 billion (profit)

2. Financial assistance to automakers and related industries

$85 billion $34 billion

3. Public-private investment program (PPIP)

$30 billion $1 billion (basically even!)

4. Grants to mortgage servicers and other programs to mitigate foreclosures

$50 billion (HAMP) $22 billion

5. Remaining TARP funds

$200 billion $23 billion

Total $700 billion $109 billion



Public-Private Investment Fund (TARP, FDIC, Fed, not yet fully operational )

TARP and private investors will contribute capital.

FDIC will guarantee debt issued by the PPIP (leveraging TARP funds up to 6:1). Funds

will be used to purchase “legacy loans” (“troubled” loans on bank balance sheets).

Fed will lend to the PPIP (leveraging gains). Funds will be used to purchase “legacy

securities” (illiquid securities whose secondary market is not functioning well).

http://www.financialstability.gov/roadtostability/publicprivatefund.html

Considered but not enacted: reverse auctions, nationalization, “bad bank(s)”






American Recovery and Reinvestment Act or “stimulus package,” $787 billion (Feb. 17)

Fiscal stimulus: about $1 trillion, about 1/3 tax cuts, 2/3 government spending

Other: GSE- guaranteed mortgages, FHA-guaranteed mortgages, moratoriums on

foreclosures, legalizing mortgage modifications by bankruptcy judges, subsidies to home

buyers, subsidies for modifications of mortgages, etc.



Fiscal policy

Government spending

An increase in G reduces I ( “crowding out”)

When is increasing G a good idea?

o Public goods with high social value

o Resources are unemployed (“Keynesian multiplier”)

If households cut C in anticipation of future taxes, the multiplier will be small

When is it a good idea to postpone paying for the increase in G (bigger budget deficit)?

o Liquidity constrained households (won’t cut C, may increase C)

o Intergenerational transfers (young to old)



Multiplier debate

Economists agree the multiplier is relevant only if resources are unemployed.

Debate is over magnitudes

o Simple Keynesian theory says the government spending multiplier should be larger than

the tax cut multiplier. However, best available estimates show a multiplier on G of

about 1.0 (there is a range from about 0.8 by Robert Barro, 1.0 by Hall and Woodward,

to 1.4 by Valerie Ramey), and a multiplier on a tax cut of about 3 (Romer and Romer).

o Greg Mankiw (Chair of the CEA for Bush) suggests a reason why the tax multiplier may

be larger. Suppose payroll taxes are cut. This makes labor cheaper. If labor and capital

are complements in the production process, this will stimulate investment spending,

adding to the direct effect of the tax cut on consumption spending (Mankiw’s blog, Dec.

11, 2008).



Temporary vs. permanent tax cuts

Economic theory (and historical “experiments”) suggest temporary tax cuts have at most a

small effect on consumption spending. “Consumption-smoothing.”

Source: WSJ, Nov. 25, 2008, John Taylor



Housing subsidy

o House prices have fallen nationally (huge variation across locations, about 25% on

average).

o High fraction of homeowners have negative equity, cannot refinance, and have an

increased incentive to walk away.

o Foreclosure rates are very high, especially on sub-prime mortgages.

o Continued imbalance between demand and supply (high vacancy rates, few housing

starts).

o Mortgage interest rates high for most of 2008, fell toward the end of the year. In 2009,

Fed policy targeted lower long-term interest rates, GSE support for mortgage market

increased, rates have been at historic lows.



International environment

Trade deficit of US balloons

Trade surpluses of China and several other emerging markets balloon

China and several other emerging markets build up large foreign exchange reservesShare of financial flows in capital flows increases

Source: The Economist, Jan 22, 2009



0=reservesof outflownet+abroadtoassetsof salesnet+CA

KA

fallreservesmuchhow

homeatinvestmentportfolionet+

ehomatFDInetNFP+NX

Balance of payments = net outflow of official international reserves

China: CA > 0, net sales of assets to abroad, net inflow of official international reserves



Two sides of the same coin

r IUS SUS IEM SEM

SUS, IUS SEM, IEM

h did h l b l i b l i ?



Why did these global imbalances arise?

US:

Government budget deficits

Low levels of private saving (wealth effect—housing wealth, equity wealth)

Attractive investment opportunities (real investment)

Low interest rates

Emerging markets:

Rapid economic growth

High saving rates

Appetite for safe, “bond-like” investments

Exchange rates

“global glut of saving”

US b d d fi i



US government budget deficit

Wall Street Journal

Gl b l i b l



Global imbalances worsen

r IUS SUS IEM SEM

SUS, IUS SEM, IEM

The “global glut of saving” outweighs the low national saving rate of the US, putting

downward pressure on world real interest rate.

This sets the stage for a “search for yield.”

L i t t t



Low interest rates

“Global glut of saving” put downward pressure on world real interest rates. Global real

interest rates were negative for several years (in the 2002-2006 period)!

US: The Fed lowered US short-term interest rates, coming out of the recession of 2001

(March – November) and 9/11 events:

Jan 3, 2001 6%

Dec 11, 2001 1.75%

Fed funds rate was 2% or below for three years (Nov 2001 to Dec 2004), and it was 1%

or 1.25% for a year and a half (Nov 2002 to June 2004)!

Why did the Fed lower rates and keep them low?

To stimulate the economy (recovery from 2001 recession, promote housing)

To fight deflation (surge of imports from China)

Japan J h d b i i f b t t d t d th d f th 1990’



Japan: Japan had been in a recession for about ten years, and toward the end of the 1990’s,

Japan slipped into deflation. To fight recession and deflation, Japan lowered its target

interest rate to zero and expanded credit (“quantitative easing”).

The yen “carry trade” flourished in this environment (borrowing in yen, investing

elsewhere at higher interest rates. US? Iceland?)

Other central banks also kept interest rates low (to help with generally difficulty economic

conditions, and adjustment to changing patterns of international trade).

China’s appetite for safe “bond like” investments



China’s appetite for safe, “bond -like” investments

o China joined the WTO in 2001

o Its low-cost workers, undervalued currency, and other developments were favorable for

FDI and portfolio investment in China, as well as China’s exports

o China’s share of world manufacturing doubled in ten years (1997 – 2007), from about

5% to 11%

o US trade deficit with China exploded from less than $50 billion to $250 billion (1/3 of

overall US trade deficit)

o China’s stock of foreign exchange reserves grew rapidly!

What to do with huge stock of foreign exchange? US Treasuries (safe, liquid)!

Holdings of US Treasuries $ bn



Holdings of US Treasuries, $ bn

Country Jan 2008 Dec 2006 Dec 2000

Japan 587 623 318

China 493 397 60

UK 160 92 50

Oil exporters 141 110 48

Hong Kong 55 54 39

South Korea 42 67 30

Taiwan 39 59 33

Singapore 38 31 28

Source: US Department of Treasury, Zandi pp. 83-84



Source: Takahashi, The Asia-Pacific Journal, Vol. 5-1-09, Jan. 28, 2009

As China’s stock of “dollars” increased it began to buy agency MBS’s (bonds backed by



As China s stock of dollars increased, it began to buy agency MBS s (bonds backed by

mortgages guaranteed by Freddie Mac and Fannie Mae). More yield, just as safe!

In an attempt to find higher-yielding assets to hold with its “dollars,” China began to buy non-

agency MBS’s (MBS’s backed by non-agency mortgages, including subprime mortgages and

alt-A’s, manufactured by investment banks). Historically safe, structured to be safe, rated as

safe by Moody’s, S&P, Fitch, etc.!

Other emerging market economies also had to find a place to park dollars generated as a



Other emerging market economies also had to find a place to park dollars generated as a

result of current account surpluses

o Rapid growth due to globalization

o High commodities prices (partly due to China’s rapid economic growth)

o US trade deficit with emerging market economies more than doubled from 2000 to

2008 ($150 billion to $350 billion)

o Total US trade deficit doubled from $400 billion in 2000 to a peak of over $800 billion in

2006

This large flow of dollars to abroad was recycled into foreign holdings of US bonds and other

fixed-income assets (US Treasuries, US corporate bonds, MBS’s, etc). These holding tripled

from about $2 trillion to almost $7 trillion from 2000 to 2008.

Summary



Summary

Global sea of funds in search of higher yield, in a low interest rate environment.

MBS’s (both agency and non-agency MBS’s) and other structures (such as CDO’s)

offered an array of risk-return characteristics.

MBS’s were structured and rated to be safe, could be insured (CDS’s), could be hedged

Any risk was spread, financial system was viewed as robust.

US financial sector was exporting financial services—it manufactured safe, “bond-like”

instruments out of various raw materials, including mortgages, and sold them abroad.

Erosion of lending standards, poor incentives in the securitization process, flawed

ratings, political pressures, etc., contributed to the bubble and the financial crisis.

However, the flow of funds into the US mortgage market contributed.

Impediments to the resolution of “imbalances” (government budget deficits,

undervalued currencies) contributed to global capital flows.

Exchange rates



Exchange rates

Source: New York Times, March 8, 2009

Before the financial crisis



Before the financial crisis

o Undervalued yuan/renminbi

o Japan’s zero-interest rate policy and the “carry trade”

o Iceland (and England, Switzerland)

After the crisis

o China’s currency is still undervalued

o Impeding resolution of imbalances

o Peg to the US dollar is causing the US dollar to fall relative to the euro (hurts euro area

exports, encourages capital inflows into the US, concerns about a new asset price

bubble in the US)

o Japan has slipped back into deflation—what effect will its policies have on resolutionof imbalances?

o Some emerging market currencies have appreciated rapidly as investors search for

yield globally—Brazil has imposed a tax on capital inflows

Effect of the financial crisis on emerging markets



Effect of the financial crisis on emerging markets

Drop in exports

o Huge drop in exports for most emerging markets—biggest contraction of world trade

in history (bigger than in the Great Depression)

o Transmission to real economy

o Potential deflation

Capital flows cut off

o Investors in emerging markets pulled their funds home

o Investment in emerging markets dropped by about half from 2007 to 2008 (from about

$900 billion to about $450 billion)

o US government budget deficit is soaking up funds that otherwise would be available for

investment around the globe

o Calls for greater IMF lending to emerging markets





Books:

1. House of Cards by William Cohan

2. Fool’s Gold by Gillian Tett

3. Financial Shock by Mark Zandi

4. Too Big to Fail by Andrew Sorkin

4. Restoring Financial Stability eds. Viral Acharya and Matthew Richardson5. This Time is Different by Carmen Reinhart and Kenneth Rogoff

6. Understanding Financial Crises by Franklin Allen and Douglas Gale

Articles:



Articles:

1. Marcus Brunnermeier, “Deciphering the Liquidity and Credit Crunch,” Journal of

Economic Perspectives, Winter 2009

2. Ingo Fender and Janet Mitchell, “The Future of Securitization,” BIS Quarterly Review,2009

3. Tobias Adrian and Hyun Song Shin, “Liquidity and Leverage,” NY Fed Staff Reports,

revised Jan 2009

4. Tobias Adrian and Hyun Song Shin, “The Shadow Banking System: Implications for

Financial Regulation,” NY Fed Staff Reports, July 2009

5. Greenlaw, Hatzius, Kashyap, and Shin, “Leveraged Losses: Lessons from the Mortgage

Meltdown,” Proceedings of the US Monetary Policy Forum, 2008

6. William Dudley, President, NY Fed, “More Lessons from the Financial Crisis,” Nov 13,

2009, http://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html

7. Gary Gorton, “Questions and Answers about the Financial Crisis,” NBER 15787, Feb 2010

8. Alan Greenspan, “The Crisis,” Brookings Papers on Economic Activity, Feb 2010

On-line resources:

http://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html






1. The Economists’ Voice, Berkeley Electronic Press (UT Library), misc articles

2. VOXEU: http://www.voxeu.org/ (online research and commentary by leading

economists)

Blogs:

1. Greg Mankiw: http://gregmankiw.blogspot.com/

2. Calculated Risk: http://www.calculatedriskblog.com/

Other:

1. Congressional Budget Office (CBO): http://www.cbo.gov/

http://www.cbo.gov/ftpdocs/112xx/doc11227/03-17-TARP.pdf

2. Federal Reserve Bank of New York, and Board of Governors of the Federal Reserve (web

sites sited above)

APPENDIX: Diamond-Dybvig model of banks and bank runs

http://www.voxeu.org/



http://gregmankiw.blogspot.com/



http://www.calculatedriskblog.com/



http://www.cbo.gov/

http://www.cbo.gov/




http://www.cbo.gov/






y g

The Diamond-Dybvig model explains how banks arise to insure investors against random

liquidity needs. Provision of liquidity insurance is one possible benefit of financial

intermediation. Here the Diamond-Dybvig model is explained using an example.

Model

The economy lasts three periods: t = 0, 1, 2.

Each agent is endowed with one “unit” at t = 0. This is the agent’s only wealth or income (he

doesn’t receive any endowment in t = 1, 2, and he can’t work).

Agents don’t want to consume in t = 0. Each agent will end up wanting to consume in either

t = 1 or t = 2. A “liquidity shock,” experienced at the beginning of t = 1, will determine this.

Let’s call agents who want to consume in t = 1 the “impatient” agents, and those who want

to consume in t = 2 the “patient” agents. In t = 0, which is when agents have to decide how

to invest their endowments, no agent knows whether his liquidity shock will cause him to be

impatient or patient!

Assume the number of agents is large enough that everyone knows 60% of agents will beimpatient, and 40% will be patient. There is no aggregate risk concerning the fraction of

agents who are impatient. But all each agent knows is that with probability .6, he’ll be

impatient and with probability .4, he’ll be patient.

There are two technologies for transferring resources across time (i.e., for transforming the



g g ( , g

ability to consume in t = 0 into the ability to consume in either t = 1 or t = 2).

The first technology is such that one unit invested at t = 0 returns one unit at t = 1 (this

technology also can be used at t = 1; one unit invested at t = 1 returns one unit at t = 2).

Investment in this technology is a liquid asset, because it yields one unit whenever it is“liquidated.”

The second technology is such that one unit invested at t = 0 yields two units at t = 2, but

only ½ if the investment is “scrapped” (liquidated) at t = 1. Thus, investment in this asset is

illiquid.

The following table summarizes these asset returns:

t = 0 t = 1 t = 2

illiquid asset –1 ½ 2

liquid asset –1 1

–1 1

The problem facing each agent in t = 0 is that if he invests in the illiquid asset, he will have a

low level of consumption (½ instead of one unit) if he ends up being impatient. On the other

hand, if he invests in the liquid asset, he’ll have a low level of consumption (one instead of

two units) if he ends up being patient.

Autarky



y

If agents have no option but to use the investment technologies themselves, each agent will

choose a diversified portfolio consisting of some of both assets. Suppose each agent has the

following utility function (called “log utility”):

( ) 2121 clnθ1+clnθ=c,cU-

where 1c = consumption in t = 1, 2c = consumption in t = 2, and θ = 1 with probability .6

( 0=θ with probability .4). The optimal portfolio consists of investing .8 units in the liquid

technology, and .2 units in the illiquid technology. The agent will consume .9 if he ends up

being impatient, and 1.2 if he ends up being patient:

t = 0 t = 1 t = 2

illiquid asset – .2 .2(1/2) = .1 or .2(2) = .4

liquid asset – .8 .8 (1) = .8 or .8 (1) = .8

total – 1 .9 1.2

Agents calculate this optimal portfolio by solving the following maximization problem:

Find X = units invested in the illiquid asset, and Y = units invested in the liquid asset, to

maximize 2121 cln4.+cln6.=c,cU , subject to the constraints Y+X5.=c1 and

Y+X2=c2 . The objective function is expected utility. The constraints reflect the

payoffs of the liquid and illiquid assets at t = 1 and t = 2. This is a constrained

optimization problem.

Liquidity insurance



Now, note agents can achieve an outcome that is better than this one, by taking advantage

of the fact that although any one agent doesn’t know whether he’ll be impatient or patient,

the proportions of agents who will be impatient and patient are known to all. Therefore,

agents can pool their resources, and take advantage of the “law of large numbers” to insureeach other!

The Diamond-Dybvig model interprets a bank as a large coalition of “young” agents that

(i) pools their endowments at t = 0, and invests them in the two assets, and (ii) uses the

proceeds of the liquid asset to pay impatient agents at t = 1, and uses the proceeds of the

illiquid asset to pay patient agents at t = 2.

In this model, a bank accepts deposits at t = 0. The deposit contract offered by the bank

specifies that an agent will get 1r units if he withdraws his deposit in t = 1, and 2r units if he

withdraws his deposit in t = 2.

Obviously, the bank invests in the liquid asset only the minimum necessary to cover

withdrawals in t = 1. (It would not make sense to use the liquid asset to cover withdrawals in

t = 2, since the return on the illiquid asset is higher if it held until then.) The proportions of the bank’s deposits it invests in the two assets are therefore determined by the deposit

contract (the promised interest rates, 1r and 2r ).

Because all agents are identical when they make their deposits (each agent has the same



endowment, and faces the same probability of being impatient), the bank simply chooses 1r

and 2r to maximize expected utility. With log utility, 1=r1 and 2=r2 . These returns, and

the bank’s portfolio, are as follows:

t = 0 t = 1 t = 2

illiquid asset – 40% 0 2 per patient agent

liquid asset – 60% 1 per impatient agent 0

total – 100% 1 per impatient agent 2 per patient agent

The bank calculates the optimal asset side of its balance sheet by solving the followingmaximization problem:

Find 1r , 2r , X, Y, 1X = amount of the illiquid investment liquidated and paid out to

impatient depositors in t = 1, and 1Y = amount of the liquid investment paid out to

impatient depositors in t = 1, to maximize

2121 rln4.+rln6.=c,cU

subject to the constraints

111 Y+X5.r ≤

112 YY+XX2r --≤

XX1 ≤ , YY1 ≤

The bank achieves higher returns for both impatient and patient depositors, compared to



returns depositors achieve if they invest on their own (in “autarky,” making direct use of the

technologies). This is possible because, due to the “law of large numbers,” banks do not

need to scrap the illiquid asset to pay impatient agents, and patient agents in effect invest

only in the illiquid asset, which has the higher return for them.A “Diamond-Dybvig bank” allows agents to insure each other against experiencing the

liquidity shock that renders agents “impatient.” For this reason, the Diamond-Dybvig model

of banks is often described as a model of liquidity insurance.

Note that the interest rates promised by the deposit contract are such that a patient investor

has no incentive to withdraw his funds early. Withdrawing at t = 1 yields a return of one unit;

this unit can then be invested in the liquid asset for one period (from t = 1 to t = 2), resulting

in one unit at t = 2. Waiting until t = 2 to withdraw yields a return of two units. This is

important because each agent has a choice of when to withdraw his deposit (t = 1 or t = 2),

and the bank cannot observe a depositor’s “type” (impatient or patient) when he shows up

to withdraw his funds. The bank can provide liquidity insurance only by offering a deposit

contract ( 1r and 2r ) that increases expected utility and induces each depositor to behave

according to his true type! Such a deposit contract is said to be incentive compatible.

Under normal circumstances, patient depositors have every incentive to behave exactly this

way. But what happens if patient depositors become worried that other patient depositors

will withdraw their funds early?

Bank run



Consider one patient depositor. If —in addition to the 60% of depositors who are

impatient—all of the other patient depositors attempt to withdraw early, the bank will have

to scrap the illiquid assets it holds. Even if it does so, the bank will have only

( ) ( ) 8.=2/14.+16. units per depositor attempting to withdraw early. (The one patientdepositor whose dilemma we are considering is a vanishingly small fraction of agents, so the

fraction of other patient agents is still 40%.) This is not enough to make good the bank’s

deposit contract, which promised 1=r1 and 2=r2 . What should the patient depositor do?

Clearly, he should join the other patient depositors in their attempt to withdraw early. That

way, he may get his funds back, or at least some of them. Thus a bank run is created.

The triggering event for a bank run in this model is not a deterioration in the quality (value)

of assets held by the bank. The bank run is a result of mass pessimism about other people’s

actions. If enough depositors expect a bank run, there will be a bank run.

There are a number of things policymakers can do to avoid or respond to an expectations-

driven bank run, including suspending convertibility of deposits in the event of a run,

imposing capital requirements on banks, and providing deposit insurance.

Comments



(1) The “mismatch” between the short duration of bank liabilities and the longer duration of

their assets plays a useful role. The fact that depositors (who own demand deposits) can

withdraw their funds any time serves to discipline bank managers if they invest depositors’

money in assets that are too risky. (Of course, deposit insurance undermines this.)

(2) The fact that bank depositors cannot coordinate with each other about whether or not to

“run” on the bank means that bank managers view it as very credible that depositors will not

renegotiate with the bank (as debt holders might), in the event that bank deposits are

dissipated due to poor management. Depositors will simply go elsewhere. This disciplines

managers.

(3) In various ways, the duration “mismatch” was extended into the so-called “shadow

banking system” during the past ten years, as banks sought to evade capital requirement.

This caused a situation where not only banks were vulnerable to runs. Bank SIV’s (and other

liquid funds) and investment banks, all of which issue short-term liabilities in order to invest

in illiquid assets, also became vulnerable to “runs.” For SIV’s and investment banks, the run

did not take the form of depositors lining up. Instead, short-term lenders to SIV’s and

investment banks declined to “roll over” the funding they were providing, because they

feared they wouldn’t get their money back. Refusing to roll over short-term funding was the

equivalent of a run for SIV’s and investment banks.

10 financial crisis-updated lecture slides

Documents