Prepared for Taiwan EFMACI 2005 Financial Instability: Theories and Applications Jing Yang Bank of...

Prepared for Taiwan EFMACI 2005

Financial Instability:Theories and Applications

Jing Yang

Bank of England


The views I express in this presentation are my own, and do not necessarily represent those of the Bank of England.

The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the

information provided.

Financial Instability:Theories and Applications


Bank of England --1997 reform

• Monetary Policy

-- price stability

-- output:

MPC monthly

‘Inflation Report’

• Financial Stability

-- to prevent systemic risk

-- publication:

‘ Financial Stability Review’


Financial Stability: A Working Definition

Financial stability is the condition where the financial system is able to withstand shocks without impairing the allocation of savings to investment opportunities in the economy.


Financial Instability in Pictures

The Real Economy

TheFinancialSystem

The Financial Instability Avalanche

♦ The Anatomy of a Crisis

– An (endogenous or exogenous) shock hits the banking system

– The shock wipes out an initial set of (inherently fragile) banks

– The first wave of failures creates a chain-reaction among otherwise healthy banks (contagion), creating a second wave of failures, etc., etc.

– When the dust clears the banking/financial system is in melt-down

– The real economy suffers

♦ Let us explore each step of the chain


Informative Surveys of Financial Stability

♦ A number of excellent surveys of the topic can be found

– De Brandt and Hartmann [2000], “Systemic Risk: A Survey”, ECB Working Paper 35

– Summer [2002], “Banking Regulation and Systemic Risk”, Bank of Austria Working Paper 57

– Kaufman and Scott [2002], “What is Systemic Risk and Do Bank Regulators Retard or Contribute to It?” Loyola University (Chicago) Working Paper

♦ More definitions of Financial Stability than you could possibly want

– Schinasi [2004], “Defining Financial Stability”, IMF Working Paper WP/04/187


I. Source of the Fragility of Banks

II. Channels of Contagion

III. Cost of Banking Crisis

The Financial Instability


I. Source of the Fragility of Banks


The Fragility of the Banking System♦ The Source of Fragility

– Banks take in deposits callable on demand…

– …but extend (relatively) long term loans

– This process is known as Maturity Transformation

– So, if every depositor wants his money back at the same time, it won’t be at the bank

– Why do banks do this? The seminal model

Diamond and Dybvig [1983], “Bank Runs, Deposit Insurance and Liquidity”, Journal of Political Economy

The Diamond-Dybvig Model♦ The Structure of the Model

– The world consists of three periods (t1, t2, t3)

– People wish to consume in t3, but may have to consume in t2

– In t1 the bank and depositors can invest in:

– a long term technology with a high payoff in t3 but a negative return if liquidated in t2;

– a short term liquid technology with a low positive return that can easily be transformed into cash in either period without loss

– On their own, risk-averse individuals choose the liquid technology as the small probability that they need the money in t2 means that the liquid technology return exceeds the expected return on the long term technology

The Diamond-Dybvig Model

♦ The Role of Banks

– Banks take deposits from everyone and:– Invest most of the money in the long term technology;– Hold a portion of deposits in the liquid technology to provide for the liquidity

needs of the depositors who want their money in t2

– Banks offer an interest rate somewhere between that offered by the liquid short term technology and that of the long term technology

– So, all depositors are better-off (when things go well), as they get higher returns then they can obtain on their own plus the option of getting their money in t2 if they need it

– In essence, banks offer liquidity insurance

The Diamond-Dybvig Model♦ Banking Fragility

– Suppose that for some random reason a greater than expected proportion of depositors seek to withdraw their cash in t2

– As withdraws continue, the expected return for the patient investors declines (liquidating the long-run investment at a loss in t2 makes the pie smaller)

– There comes a point where even a patient investor is better off getting his money in t2 than waiting. Anticipating this, everyone wants to get their money out first…

– BANK RUN!!!!

From Banks to the Banking System

♦ Limitations of a Single Bank Analysis

– A single bank failure won’t have much affect on the stability of the financial system

♦ A Banking System

– The system consists of a number of Diamond/Dybvig banks– Individual banks experience liquidity shocks– The banks are linked together via the interbank loan market (the payment

system)– The banks can therefore insure each other against an idiosyncratic liquidity

shock by borrowing or lending on the interbank market

♦ The Banking System is one big bank

A Banking Crisis♦ Normal Times

– If an individual bank experiences a liquidity shock, then it can meet that extra liquidity demand by borrowing on the interbank market rather than liquidate a portion of its long term assets (at a loss)

– Individual bank runs become less likely

♦ Crisis

– Suppose that a liquidity shock hits the economy as a whole

– If the shock exceeds the liquid reserves of the banking system, then moving liquidity around via interbank loans will not suffice

– Individual banks must then liquidate long-term assets (at a loss), making the patient investors who don’t withdraw worse off…

♦ BANK RUNS!!!!

Key Papers

♦ Diamond and Rajan [2001], “Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking”, Journal of Political Economy 109

♦ Allen and Gale [2000], “Financial Contagion”, Journal of Political Economy 108

♦ Chen [1999], “Banking Panics: The Role of First-Come, First-Served Rule and Information Externalities”, Journal of Political Economy 107


II. Channel of Contagion

Getting the Snowball Rolling:Channels of Contagion

♦ Bank Runs

– Random liquidity demands trigger bank runs that cause system melt-down ♦ Interbank exposures

−Bank failures spread because failing banks lack the resources needed to repay their interbank loans to otherwise healthy banks, causing them to fail in turn

♦ The Asset-Price Channel

−An individual shock that causes many banks to sell related assets at the same time, overloading the market for such assets, pushing prices down further

♦ Exposure to Common Shocks (not really contagion)

– Banks with big exposures to the same risk can all be wiped out by a big shock


Channel 1: bank runs


Bank Runs and Transaction Costs♦ Taking all of your money out of the bank isn’t free

– You will have to find another bank

– You might get robbed

♦ So, one might think that people would need a very good reason to withdraw all of their cash

– If everyone knows that everyone faces a big cost for withdrawing all of their cash, sunspot/panic driven bank runs are far less likely to occur


Bank Runs in the Real World

♦ Bank runs don’t actually happen…

– Reviewing almost 3,000 bank failures over the period 1865 to 1936 (mostly before deposit insurance), O’Conner [1938] found that runs or loss of public confidence was cited as the reason for the failure in less than 5% of cases

– Deposit insurance makes runs even less likely

Bank Runs: Key Empirical Papers– O’Conner [1938], The Banking Crisis and Recovery Under the Roosevelt

Administration, Chicago: Callaghan and Co.

– Calomiris and Mason [2000], “Causes of U.S. Bank Distress During the Depression”, NBER Working Paper no. 7919

– Calomiris and Mason [1997], “Contagion and Bank Failures During the Great Depression: The June 1932 Chicago Banking Panic”, American Economic Review 87

– Saunders and Wilson [1996], “Contagious Bank Runs: Evidence from the 1929-33 Period”, Journal of Financial Intermediation 5

– Benston, Eisenbeis, Horvitz, Kane, and Kaufman [1986], Perspectives on Safe and Sound Banking, Cambridge: MIT Press


Channel 2: inter-bank linkages


Contagion Through Connections: The Interbank Loan Channel

♦ The interbank loan market is extremely active

♦ This loans create exposures between banks

♦ So, if one bank fails, it is at least logically possible that it will drag its creditors down with it

♦ People have explored this possibility through case studies and through simulations of bank failures using the actual (estimated) matrix of interbank exposures for many countries

Interbank Exposures:A Case Study of Continental Illinois

♦ Continental was the 7th largest US bank at time of failure in 1984

– Assets in excess of $32 billion

♦ Continental was extremely active in the interbank market

– Weird Illinois banking regulations limited each bank to one branch

– Even with a big branch, one is not going to become the 7th largest bank in the on the basis of local deposits alone

– Continental therefore financed its expansion with interbank loans

– At the time of failure, Continental was the largest correspondent bank in the US, with either loans or deposits from 2300 other banks

Continental Illinois: What Happened♦ In the event, the FDIC bailed all creditors out

♦ But, the House Banking Committee investigated what would have happened without the government bailout

– Assuming losses of 60 cents on the dollar for Continental’s assets

– 27 small banks become insolvent

– 56 additional small banks take a big hit ( >50% of capital)

– Total losses to heavily affected banks: < $500 million

Contagion Through Interbank Exposures: Simulation Studies

♦ Method – Estimate the matrix of interbank exposures using real data for the

banking system as a whole

– Suppose that a given bank fails or…

– …Model overall bank exposures and hit the banking system with a shock such that an initial set of banks fail

– Elsinger, Lehar, and Summer [2003]

– Assume a loss given default on a failed bank’s assets

– Trace the impact of initial and any follow-on bank failures through the system using the estimated interbank exposure matrix


Simulation Studies: Results

♦ Results

– Every study finds the same thing: with a large value of loss given default, there is limited contagion.


Simulation Studies: Key Articles

♦ Furfine got the literature rolling, and the idea was contagious!

– US: Furfine [2003], “Interbank Exposures: Quantifying the Risk of Contagion”, Journal of Money, Credit, and Banking 35

– Belgium: Degryse and Nguyen [2004], “Interbank Exposures: An Empirical Examination of Systemic Risk in the Belgian Banking System”, National Bank of Belgium Working Paper

– UK: Wells [2002], “UK Interbank Exposures: Systemic Risk Implications”, Financial Stability Review


– Germany: Upper and Worms [2002], “Estimating Bilateral Exposures in the German Interbank Market: Is there a Danger of Contagion?”, Deutsche Bundesbank Discussion Paper 9

– Austria: Elsinger, Lehar, and Summer [2003], “The Risk of Interbank Credits: A new Approach to the Assessment of Systemic Risk”, Bank of Austria Working Paper


Channel 3: The Asset Price Channel


The Asset Price Channel

♦ Demand curves slope down in securities markets too

– Markets are not infinitely deep

– As more people sell a given asset, the natural buyers: (i) exhaust their demand; (ii) hit their risk tolerance; (iii) run out of money

– The equilibrium price of the asset falls (for at least a while)

– Pioneering work: Grossman and Miller [1988]


Assets Price Channel

♦ The snowball

– A trader knows that he must sell security A, that others may have to sell A, and that A’s demand curve has a steep slope at the time

– Everyone who is long in A wants to sell first

– A race for the door ensues (everyone rushes to sell)

– The rush to sell causes the panic that all the traders were dreading

♦ The mountain down which the snowball falls…

– An initial market price fall puts many traders at a level close to their loss-limits, encouraging them all to close out their positions

– Morris and Shin [2003]

– Risk neutral traders who may have to sell next period all sell now to avoid the possibility of selling during a panic, causing the panic instead

– Bernardo and Welch [2003]

– Analytically equivalent to a Diamond/Dybvig Bank run

♦ Why doesn’t the market automatically stabilize?

– Suppose that trader Z knows that other traders have to sell

– Z will benefit by starting an asset run

– Prices will fall to a below long-run value level, giving Z a chance to buy low (during the panic) and sell high (after normal conditions apply)

– Far from stepping in to provide liquidity during a panic, then, traders in Z’s position help the panic along

– The market will not automatically stabilize


Asset Price Contagion

♦ The problem: conflict between individual incentive and collective incentive

– Runs start because each individual trader ignores how his actions affect the probability of a crisis

– Individually rational to run, but collectively daft

– Privately rational (but collectively inefficient) selling then leads to a crash


Asset Price Contagion: Key Papers

♦ A new literature

– Grossman and Miller [1988], “Liquidity and Market Structure”, Journal of Finance 43

– Bernado and Welch [2003], “Liquidity and Financial Market Runs”, Forthcoming in the Quarterly Journal of Economics

– Morris and Shin [2003], “Liquidity Black Holes”, Forthcoming in Review of Finance

– Schnabel and Shin [2003], “Foreshadowing LTCM: The Crisis of 1763”, LSE Working Paper


Channel 4: common shock

What Does Cause Banks to Fail - common shock channel

♦ Individual banks fail due to adverse economic conditions:

-- managerial Incompetence/Rogue Trading: Barings

– Adverse Conditions: The most common factors cited for bank failure in O’Connor’s [1938] survey of why banks failed were local financial distress and incompetent management

♦ One might then think that waves of bank failures occur because many banks pursue strategies that create exposures to the same adverse shock…

An Aside: Prudential Supervision

♦ If (unhealthy) banks fail because of macro factors, is there any point to prudential supervision?

♦ Yes!

♦ As banks approach failure, their incentive to gamble for resurrection becomes enormous

– If a bank increase the risk in its portfolio, it can stick the deposit insurance fund if it loses and keep the gains if it wins

♦ If regulators do not monitor banks to see which banks are in this position, and do not act promptly to shut-down any bank they find in this position, then the cost of a financial crisis can rise dramatically


Common Shocks: Key Papers♦ This literature is vast, but here are a couple of papers to get one started

– Calomiris and Mason [2000], “Causes of U.S. Bank Distress During the Depression”, NBER Working Paper no. 7919

– Demirguc-Kunt and Detragiache [1998], “The Determinants of Banking Crises in Developing and Developed Countries”, IMF Staff Papers 45

– Kaufman and Scott [2002], “What is Systemic Risk and do Bank Regulators Retard or Contribute to it?”, Loyola University (Chicago) working paper

– Kaufman and Seelig [2002], “Post-Resolution Treatment of Depositors at Failed Banks and Severity of Bank Crises, Systemic Risk, and Too-Big-To-Fail”, Economic Perspectives (Chicago Fed)


III. Consequence of Financial Crisis

Cost of Financial Instability

Output losses (per cent of GDP)Sample

sizeAll Countries Systemic

bankingcrisis

countries

Non-bankingcrises paircountries

All 58 13 19 6 Developed Countries

10 19 32(a) 6(b)

Emerging Countries

48 11 16 6

Banking crisis Alone

12 n/a 9 n/a

Banking and Currency crisis

17 n/a 26 n/a

Currency crisis Alone

14 n/a n/a 18

Neither crisis 15 n/a n/a -5

Counter Example: Norwegian

♦ During the Norwegian banking crisis, banks holding 95% of all commercial bank assets became insolvent…

♦ …Without affecting the health of the Norwegian Corporate Sector

– Ongena, Smith, Michalsen [2003]

♦ Norway’s well developed and well working financial markets provided corporates with a robust alternative method to acquire financial services

– Strong protection for minority shareholders

– Transparent accounting

– Strong public markets


Summary

• Financial crises are ‘public bad’—create externality and cause output losses.

• Source of contagion: liquidity shock.• Channels of contagion: bank run; inter-bank

market; asset price cascade and common shock.• Financial market can compliment banking system

as financial intermediation.How does the structure of a financial system

contribute to its stability?

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