Table of contents
2 Self-fulfilling prophecies on bank runs
3 Implications on bank runs
4 Lender of last resort
5 Deposit insurance
6 Capital adequacy requirements
List of figures
1 From Bank Run through Bank Panic and Contagion
In this paper the worldwide dreaded and at the same time exciting scenario of bank runs and their emergence is described and the consequences are discussed. We will in this context discover what leads people to lose confidence and withdraw their money as well as what the bank run implications could mean for the society. Later on, there will be an overview over the usual regulatory tools and mechanisms to prevent exactly these implications. The key of the following analysis lies in the evaluation and prevention of possible moral hazard evolving from those interventions.
2 Self-fulfilling prophecies on bank runs
A bank run arises when many creditors of a bank are demanding abruptly their deposits back. At that stage it concerns only one bank, so until here we have a non-systemic risk (Apostolik/Donohue 2015, p. 76). It can also be described as a panic among nearly all depositors who are scared of losing their money in case that the bank goes bankrupt. That is of course an undesired state, because beyond the problems of the affected bank there are lots of companies of the real economy who rely on bank loans which could be terminated now in case of liquidation (Diamond/Dybvig 1983, p. 402). So we are dealing with the loss of confidence in the stability of the bank - if other depositors are expected to withdraw because of a special situation or just to avoid losses, then every saver will run to the bank.
That leads us to the definition of self-fulfilling prophecies: ‘If men define situations as real, they are real in their consequences’ (cited in Merton 1948, p. 193). This is a special feature of human behaviour, nowhere else in nature are predictions of events their own trigger. It starts with a wrong assessment of a situation followed by a change in behaviour, which makes the incorrect valuation come true. An example could be the expectation of a war which leads to aggressive defense behaviour which eventually has the consequence of a real war (Merton 1948, p. 195). An important point is, that the acting persons mostly don’t realize that their own false belief is responsible for the negative outcome because it is eventually confirmed (Biggs 2009, p. 294).
Translated to the bank run scenario another aspect emerges: Even those depositors who know that concerns regarding the bank’s liquidity are unfounded have an incentive to run because they know that others are believing that the rumors are true and so they are going to withdraw (Singh 2009, p.183). The idea that a whole bank gets into serious trouble because of a false assumption combined with the following herdal behaviour of anxious savers gives reason to worry. Diamond and Dybvig (1983, p. 409) characterize the run situation as a bad equilibrium where everybody demands his deposit anticipating that the bank’s asset value is lower than the deposit value. This process leads to the worst outcome for all participants: We have a destroyed risk-sharing between agents, lower savings returns up to complete losses of deposits, an interruption of real economic processes through loan callings and contagion effects. The whole self-fulfilling bank run scenario can emerge through a simple coincidental trigger, e.g. negative earnings, a bad forecast or a general economic downturn independent of the real situation of the specific bank (Ibid., pp. 409-410). ‘The problem is that once they have deposited, anything that causes them to anticipate a run will lead to a run.’ (Ibid.) There could be also some ‘slightly noisy signals’ (Zhu 2001b, p. 2) concerning the fundamental economic condition which work like a catalyst for bank runs. This supports the contrarian view to the Diamond-Dybvig model, that bank runs are random-based. Evidence shows that there is a connection between bank crises and the state of the business cycle. Furthermore it is not explained in the model where expectation shifts of agents really result from (Zhu 2001a, p. 2).
In this section one important aspect becomes clear: The liquidity and risk transformation functions of banks which are the breeding ground of their existence are the same factors which make them assailable to bank runs. Furthermore it is shown that human self-fulfilling prophecies are an extremely dangerous factor for the stability of banks because they are not predictable. Finally, the meaning of self-fulfilling prophecies in the context of bank runs is perfectly illustrated in the following citation: ‘It would make sense for a bank to have a large lobby (or fast bank tellers), because if a line to withdraw extended out to the street, passersby may conclude that a run is in progress.’ (Diamond 2007, p. 14).
3 Implications on bank runs
After covering bank runs and their self-fulfilling prophecies in the previous chapter we will now discuss further implications. Considered isolated, a single bank run does not insult the whole banking system because the money is likely transferred to other banks which results in a zero effect to the reserves of the banking system (Dwyer/Gilbert 1989, p.44). If the first run is not handled effectively, systemic effects can emerge, i.e. the run ‘spreads’ and other banks experience runs, too. Systemic risk in that context is defined as a cumulation of losses of connected institutions in form of a chain reaction resulting from a specific event (Kaufman/Scott 2003, p. 372).
The first type of systemic risk, where a bank run multiplies itself, is called a ‘panic’ (Apostolik/Donohue 2015, pp. 75-76). Here we have herdal behaviour among investors who are looking urgently for safe havens. Banks with similar risk profiles as the originally affected institution are the first exposed to panic runs. Later, there is no distinction between solvent and insolvent banks as well as domestic or international located (Kaufman/Scott 2003, p. 373-374). That forces financial institutions to sell their assets what drives down their market values (Dwyer/Gilbert 1989, p.46).
At that stage bank panics can increase fluently to ‘contagions’, the second and worst part of bank-run induced systemic risks, like shown in figure 1. The decline in collateral values in bank balance sheets is characteristic for contagions as it has massive negative implications for the worldwide economic system, e.g. corporate spillover effects like significant downturns and crises combined with high grades of unemployment (Vila 2000, p. 232). The larger the primarily affected bank, the broader will be the shock for the entire system. This is enforced by contemplation of the normally liquidity-supplying interbank market: ‘When a region of the world is hit by a liquidity shock and the world demand for liquidity is larger than the world supply, international interbank linkages may propagate the shock to other regions.’ (Sbracia/Zaghini 2001, p. 251) If we finally consider the additional risk of failure in derivative positions due counterparty risk, what happened in the financial crisis of 2008, the picture of the ‘burning chain reactions’ becomes even more dramatic (Dragan et al. 2013, p. 179). On the other hand, ample capital and lower leverage give infected banks the possibility to withstand and stop the transmission chain of losses (Kaufman/Scott 2003, pp. 375-376). This thought will be developed further in chapter 6.
Abbildung in dieser Leseprobe nicht enthalten
Figure 1, source: Apostolik /Donohue 2015, p. 76
4 Lender of last resort
A widely discussed regulatory response to avoid the previous mentioned contagious effects is the concept of the central bank being the lender of last resort (LOLR). It includes the simple idea that liquidity in form of emergency funds is supplied to banks with liquidity and solvency problems (Apostolik/Donohue 2015, p.76). This economic protection ensures that households and corporations are further provided with money and the system doesn’t collapse, so the central bank acts as a re-insurer. That is technically possible in an infinite scope because the central bank can create money from scratch (Tucker 2014, p.12).
LOLR-presence has the main benefit that if every market participant knows beforehand that all banks will be rescued, then there is little foundation for a bank run. If it happens nevertheless, the LOLR provides enough liquidity that adverse asset sales can be avoided and spreading effects like panics or contagion will become unlikely (Ibid., p.15).
On the other hand, there is the obvious drawback of stimulated moral hazard. If every bank is rescued in every case of illiquidity, there is no more incentive for investors to analyse its risk and to monitor the banking activities (Ibid., p. 20). In fact, there would be no difference to government lending, with the advantage of a ‘free lunch’ in form of the individual bank risk premium. Furthermore, the bank could engage in extraordinary risky operations, distribute the profits to shareholders and managers and in the case of failure, the LOLR would pay the bill and socializes the losses. That would be indeed better than a contagion but it creates an environment, which is far away from free market powers as well as from healthy and fairly priced risk-return-profiles. Another disadvantage for the bank itself lies in the bad reputation of bail-outs: ‘If it is believed that the central bank will not turn away insolvent banks, then it becomes toxic for a solvent but illiquid bank to borrow from the central bank if there is any chance of that becoming known.’ (Ibid.) So the executive-driven avoidance of stigmatized rescue could lead to a worsening of the situation.
A key for solving the moral hazard problem lies in the effective distinction between insolvent and illiquid institutions paired with effective stress tests and asset quality reviews (AQR) on a regular base, as well as sufficient collateral requirements. But that doesn’t eliminate the incentive to take higher than normal liquidity risk. Another proposal is a deterrent high LOLR interest rate, which could be helpful but not the only solution (Ibid, pp. 21-22). Such a penalty rate ensures that the LOLR funds are not used for current operations (Freixas et al. 2004, p. 3). In connection with that an ‘outside spread’ for the collateral assets traded by the central bank is proposed, which has the same effect as the penalty rate (Domanski/Sushko 2014, p. 6). Lastly there is the suggestion, that bank balance sheets have to be customised in much more detail, so that risky operations can be punished by the market before the crisis evolves (Unit 6, p. 15).
To sum it up, the LOLR concept is very helpful to defeat bank-run-driven contagions. It has nevertheless the bitter moral hazard aftertaste which can only be controlled through an effective pre-crisis system of stress tests, AQR, lending conditions etc. which ensures that only fundamental strong banks get that kind of liquidity support.
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- Arno Hetzel (Autor), 2016, The impact of self-fulfilling prophecies on bank runs, München, GRIN Verlag, https://www.grin.com/document/379729