Econ 208

Marek KapickaLecture 16

Financial Intermediation

Wednesday

Last class! Review: If you want me to go over

specific things, email me or ask me on Wednesday

A Liquidity Problem

1. Autarkic Solution2. Market Solution3. Efficient Solution4. Banking Solution

5. Banking SolutionEquilibrium without runs:

1

1

𝐶1

𝐶2

𝐹

𝐶1∗

𝐶2∗

Equilibrium without runs

5. Banking SolutionEquilibrium with runs

Assume that the bank operates under a sequential service constraint: Everyone who comes to the bank in

period 1 is paid , until bank resources are depleted

The liquidated value of all the bank’s assets is𝑆=𝑦 ≤1

5. Banking SolutionEquilibrium with runs

Suppose that everyone decides to withdraw in period 1

Since

1. Not everyone in can be paid in period 1

2. Those who wait until period 2 will get nothing

The bank will become insolvent

𝐶1>1≥𝑆

5. Banking SolutionEquilibrium with runs

A payoff matrix: late consumer (rows) vs every other late consumer (columns):

Note: the run/run payoff is the expected payoff

There are two equilibria: No run/No run (good equilibrium) Run/Run (bad equilibrium)

Run No Run

Run

No Run

5. Banking SolutionEquilibrium without runs:

1

1

𝐶1

𝐶2

𝐹

𝐶1∗

𝐶2∗

Equilibrium without runs

Equilibrium with runs

𝑦

𝑦

4. Banking SolutionHow to eliminate the bad equilibrium?

Ways to eliminate the bad equilibrium Suspension of Convertibility Deposit Insurance

Each of them has its own costs…

4. Banking SolutionSolution 1: Suspension of convertibility

Suppose that the bank can refuse to pay deposits in period 1 if the number of withdrawals equals the number of early consumers Then waiting guarantees in period 2 Thus, no late consumers decide to run

4. Banking SolutionSolution 1: Suspension of convertibility

Examples: United States, Great Depression:

A series of banking panics (October 1930, March 1931, March 1933), increasingly more severe

Bank Holiday, March 6-March 13 1933 Banks were allowed to open only if

licensed by the government Argentina, 2001

4. Banking SolutionSolution 1: Suspension of convertibility

Costs:1. If the number of early consumers is

unknown then the bank does not know when to suspend convertibility

2. Suspension of convertibility is not time consistent

The bank would like to promise ex ante to suspend convertibility, but when the time comes, it would reconsider

4. Banking SolutionSolution 1: suspension of convertibility

early?

late?early?

??

4. Banking Solution Solution 2: Deposit Insurance

Suppose the government guarantees that each depositor will receive Tax all consumers in period 1 to

finance this in case bank run happens Then no late consumer will withdraw

in period 1 even if he believes that everyone else withdraws in period 1

Bank run will not occur

4. Banking Solution Solution 2: Deposit Insurance

Problems with Deposit Insurance: Moral Hazard Bank may take too much risk

If successful, profits If unsuccessful, insured

May create “too big to fail” problem”

4. Banking Solution Solution 2: Deposit Insurance

1934: Federal deposit Insurance Corporation (FDIC) established deposits up to $250000 insured

Raised from $100000 in 2008 No large bank runs on commercial

banks since the Great Depression

How is this related to the 2007-2009 financial crisis?

Read Gary Gorton: ``Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007” (on the web)

2. Shadow BankingWhat is shadow banking?

Instead of people depositing money in the bank, firms and financial institutions deposit in a different financial institution

The market is called repo market The “deposit” is collateralized with

some assets The collateral can be used elsewhere

2. Shadow BankingExample of repo

Microsoft: $1 million in idle funds Makes a loan to Goldman Sachs for

a week GS uses $1 million worth of

Treasury bills as collateral After a week, Microsoft gets back

$1 million plus interest, GS gets back Treasury bills

2. Shadow BankingSimilarities with commercial banking

No 1: Deposits can be withdrawn at any

time

~ Repo agreement can be terminated any time

2. Shadow BankingSimilarities with commercial banking

No 2: Deposits can be used in transactions

(checks)

~ Collateral can be reused in other transactions (rehypothecation)

2. Shadow BankingDevelopment of the shadow banking

Over the last about 25 years, the importance of the repo market has grown dramatically

Increased importance of collateral The size is estimated to be about 10

trillion USD For comparison: US GDP: about 14 trillion

USD

2. Shadow BankingDevelopment of the shadow banking

Shadow BankingWhat is a haircut?

A % difference between a loan and the value of a collateral

If Meryll Lynch borrows 95 million USD and is required to put up 100 million USD in collateral, the haircut is 5%

Comparison with commercial banking 0 haircut is like checks being perfect

substitutes to cash Positive haircut is like checks being traded

at a discount

Shadow BankingA panic (run on repo)

In a commercial banking, Everyone wants cash and no one wants deposits Deposits and are traded at discount Currency famine: disruption of transactions

On a repo market, Everyone wants cash, and no one wants collateral Collateral is traded at a discount (haircuts increase) Shortage of collateral: disruption of transactions

Shadow BankingA panic (run on repo)

One important difference: On a repo market, a decrease in

the value of collateral forces financial institution to sell assets. That decreases the value of the collateral Amplifies the response

Shadow BankingA run on repo

Shadow Banking2007-2008

A Run on repo happened in 2007-2008

Why did the bank run happen? Triggered by a “shock” (decrease

in housing prices?) There is nothing like

suspension of convertibility deposit insurance

in the shadow banking system!

The lesson to take from this

2007 was very much like 1907!