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 balance 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
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
Loan to BANK #5 5 5 Borrowed from BANK #3
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
Cash 10 100 Deposits
Loan to BANK #4 5 5 Borrowed from BANK #2
Loan to BANK #5 5 5 Borrowed from BANK #3
Common risky asset 80
Unique risky asset 30 20 Equity = A – L

BANK #1
A L
Cash 10 100 Deposits
Loan to BANK #4 5 5 Borrowed from BANK #2
Loan to BANK #5 5 5 Borrowed from BANK #3
Common risky asset 80
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
Cash 10 100 Deposits
Loan to BANK #1 0 5 5 Borrowed from BANK #7
Loan to BANK #6 5 5 Borrowed from BANK #8
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
Cash 10 100 Deposits
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 insolvent” 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 and
MBS’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 Liabilities
Reserves 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
 105 - 115 5 - 15
Value of assets changes by = -8.7% . Value of capital changes by = -66.7% !
115 15

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 bank
is 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 the
investment.

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 100
Loans 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(20 - 5) + .5(0 - 5) = 5 .
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 possibly
for 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!
“Heads 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 from
downside 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, by
making 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 rate
http://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 3.00
January 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%.
2006
June 29 25 ... 5.25
May 10 25 ... 5.00
March 28 25 ... 4.75
January 31 25 ... 4.50

2005
December 13 25 ... 4.25
November 1 25 ... 4.00
September 20 25 ... 3.75
August 9 25 ... 3.50
June 30 25 ... 3.25
May 3 25 ... 3.00
March 22 25 ... 2.75
February 2 25 ... 2.50
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.
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 4.00
April 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 Securities
Lending 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 when
it 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
2,500
CPFF
AMLF
Maiden Lane II & III
AIG
2,000 Maiden Lane
PDCF
Foreign currencies
TAF
Discount window
1,500 RPs
$ billions

Securities, lent
Securities, not lent

1,000

500

0
Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09
 Fed's Balance Sheet, liabilities
2,500
Treasury, supplementary
Treasury, general
Bank reserves
2,000
Reverse RPs
Currency

1,500
$ billions

1,000

500

0
Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09
 1,600 Bank reserves
Currency

1,200
$ billions

800

400

0
Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09
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.
Government responses
TARP (Troubled Asset Relief Program, Oct. 2008)

Goal at the time TARP was passed was to purchase “troubled assets” from banks.

By getting hard-to-value, illiquid assets off the balance sheets of banks, TARP intended to
increase liquidity and normal functioning of financial markets.

TARP transactions:

1. Capital purchases (taking an equity stake) and financial support for financial
institutions

2. Financial assistance to automakers and related industries

3. Public-private investment program (PPIP)

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

http://www.cbo.gov/ftpdocs/112xx/doc11227/03-17-TARP.pdf
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 reserves
Share of financial flows in capital flows increases

Source: The Economist, Jan 22, 2009

Balance of payments accounting

National saving: S = Spr + Sgov

Current account: CA = NX + NFP

Relationship: CA = S – I

Identity: CA + KA = 0

CA < 0 (“trade deficit”)  KA > 0 (“borrowing from abroad”). US!

Common patterns:
o High investment rate despite low national saving
o “Consumption boom”
o Government budget deficit

CA > 0 (“trade surplus”)  KA < 0 (“capital outflows”). China, other emerging markets!
 KA




CA + net sales of assets to abroad + net outflow of reserves = 0

  


NX+NFP net FDI at hom e how much reserves fall
+ net portfolio investment at home

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

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
“global glut of saving”
High saving rates
Appetite for safe, “bond-like” investments
Exchange rates
US government budget deficit

Wall Street Journal

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.”

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: 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

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

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
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
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

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

Source: New York Times, March 8, 2009

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 resolution
of 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

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
Miscellaneous references

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 Richardson
5. This Time is Different by Carmen Reinhart and Kenneth Rogoff
6. Understanding Financial Crises by Franklin Allen and Douglas Gale
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:
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
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 be
impatient, 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
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
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”):
U(c1 , c2 ) = θ ln c1 + (1 - θ) ln c2
where c 1 = consumption in t = 1, c 2 = consumption in t = 2, and θ = 1 with probability .6
( θ = 0 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 U(c 1 , c 2 ) = .6 ln c 1 + .4 ln c 2 , subject to the constraints c1 = .5X + Y and
c2 = 2X + Y . 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 insure
each 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 r1 units if he withdraws his deposit in t = 1, and r2 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, r1 and r2 ).
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 r1
and r2 to maximize expected utility. With log utility, r1 = 1 and r2 = 2 . 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 following
maximization problem:
Find r1 , r2 , X, Y, X1 = amount of the illiquid investment liquidated and paid out to
impatient depositors in t = 1, and Y1 = amount of the liquid investment paid out to
impatient depositors in t = 1, to maximize
U(c 1 , c 2 ) = .6 ln r1 + .4 ln r2
subject to the constraints
r1 ≤ .5X 1 + Y1
r2 ≤ 2(X - X1 ) + (Y - Y1 )
X1 ≤ X , Y1 ≤ Y
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 ( r1 and r2 ) 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
.6 (1) + .4 (1 / 2) = .8 units per depositor attempting to withdraw early. (The one patient
depositor 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 r1 = 1 and r2 = 2 . 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.