Edmund Cannon
Banking Crisis
University of Verona
Lecture 1
2
Plan for today
What is a bank and what makes it different?
Different types of bank
What is a “run” on a bank?
Policies to prevent runs.
Description of Northern Rock and MMMFs
Types of bank
3
Retail banks (in UK: “High Street banking”)
Receives money from depositors
Individuals and SMEs
Mortgage banks
Investment banks
In USA under Glass Steagall (1934-99)– not allowed to
receive deposits
Engages in riskier trading activity
Universal banking
In Europe retail and investment banking not separate
Shadow banking
4
What do banks do?
Intermediary (broker): match savers to borrowers
Selection and monitoring (asymmetric information)
Risk pooling
Financial advice
Transaction services (eg payment services)
Maturity transformation
Compare and contrast rôle of other (financial) institutions:
General assurance (insurance) company
Life assurance company
Mutual fund
Hedge fund
Ratings agency
Stock broker
Accountant
Actuary
5
Maturity Transformation
Banks are relatively unusual in providing this.
Productive investment takes time
Only possible to get money back in the future;
or
Sell asset at unknown price before investment
reaches maturity.
Revision of basic money supply model of banking
6
Risk is usually ignored
Banks maintain a ratio
M
{
Total
Money Supply
=
Cash
³ Depositors who will withdraw
Deposits
m ´ H
{
{
Money
Multiplier
Outside
Money
Assets
Liabilities
Loans
€90
Cash
€10
Total
€100
Deposits
€100
Total
€100
7
The run on Northern Rock
http://www.youtube.com/watch?v=EyVk8EI6asQ&feature=related
8
Facts on bank runs
Bank runs common in 19th century and early 20th century.
Sept 2007: Northern Rock (UK) suffers a run. Bradford &
Bingley and Alliance & Leicester banks narrowly avoided runs.
Sept 2008: Run on Money Market Mutual Funds (USA).
In the UK, until 2007, no run on a bank since Overend-Gurney
in 1866 (OG was a brokerage bank).
Nb UK did have financial crises (eg 1914)
9
Facts about Northern Rock
NR was a building society (mutual savings and mortgage
institution) which de-mutualised in 1998 to become a bank.
It expanded its mortgage loan book massively (23% per year),
financed partly by short-term loans (ABCP).
On 9 Aug 2007 the international ABCP market collapsed, and
Northern Rock could not roll over loans.
From 14 Aug 2007 to 14 Sep 2007 the Bank of England and
FSA tried to resolve the situation secretly.
When the problem (and lack of solution) became public
depositors panicked and withdrew funds.
10
Diamond-Dybvig Model of Bank Runs
There are two types of depositor:
Type A wishes to consume in period 1
Type B prefers to consume in period 2
All depositors invest £1 in period 0.
Any depositor can withdraw in period 1.
Proportion of type A depositor is not known with
certainty.
The bank invests some funds in a project which yields a
return in period 2 and is difficult to sell in period 1:
This suggests there is some “market imperfection”.
11
The DD Model: Payoff to an individual of type B
Decision of one individual Type B
depositor
Withdraw deposit Withdraw deposit
in period 1
in period 2
Behaviour of
all of the
other
depositors
Fewer than r
depositors withdraw
(repaid from bank’s
cash balances)
(ie, both
Type A and
Type B)
More than r
depositors withdraw
(leading to distress
sale of assets)
1
2
0.5
0
12
Potential Solutions
Prudential management of assets by banks (hold enough cash
or liquid assets).
Bagehot (1873) – central bank intervention.
Deposit insurance (Diamond-Dybvig; FDIC, 1934).
Temporary closure of banking system, or individual banks join
together to issue joint bonds.
More radical solutions (eg Kotlikoff: conventional banking is
forbidden).
13
Bagehot (1873) Lombard Street
Walter Bagehot – central bank intervention to
increase the money supply and buy good quality
financial assets (bank bonds or bills).
The private bank has an asset of good quality but it cannot
sell the asset for its full price.
Therefore the Bank of England (central bank) should buy
good quality assets at the full price.
This makes a panic on this bank less likely.
If a panic occurs on this bank it is less likely to spread to other
banks (no contagion).
14
The DD Model with deposit insurance
Payoff to an individual of type B
Decision of one individual Type B
depositor
Withdraw deposit Withdraw deposit
in period 1
in period 2
Behaviour of
all of the
other
depositors
Fewer than r
depositors withdraw
(repaid from bank’s
cash balances)
(ie, both
Type A and
Type B)
More than r
depositors withdraw
(leading to firesale of
assets, gov’t provides
insurance)
1
2
0.5+0.5 = 1
0+1 = 1
15
The DD Model with deposit insurance
Payoff to an individual of type B
Decision of one individual Type B
depositor
Withdraw deposit Withdraw deposit
in period 1
in period 2
Behaviour of
all of the
other
depositors
Fewer than r
depositors withdraw
(repaid from bank’s
cash balances)
(ie, both
Type A and
Type B)
More than r
depositors withdraw
(leading to firesale of
assets, gov’t provides
insurance)
1
2
1
1
16
Deposit Insurance in the USA
Introduced in USA by 1933 Banking Act (Glass-Steagall).
Federal Deposit Insurance Corporation (FDIC) monitors banks
and provides deposit insurance.
Savings-and-loans institutions regulated by complementary
Federal Savings and Loans Insurance Corporation (FSLIC –
National Housing Act 1934)
S-&-L receive deposits and lend money to mortgages
Allowed to have current accounts from 1970s
Make huge real estate losses in 1980s
FSLIC protects depositors but merged with FDIC after
receiving billions of dollars of taxpayer support
17
Bank runs: review of theory
Bank runs due to maturity transformation and imperfect
financial markets.
Diamond-Dybvig model shows how a solvent bank can suffer
a run (multiple Nash equilibria) and how deposit insurance
can prevent this.
Traditional method is central bank intervention (Bagehot).
Questions:
Empirical evidence for DD model?
What about banks which do not take deposits?
Are there problems with deposit insurance?
18
Bank runs: (i) Overend-Gurney
Overend-Gurney (1866) was the last bank to suffer a run in
the UK until Northern Rock.
The primary business of OG was re-discounting bills of
exchange (i.e. it acted as a bank to other banks).
1855 Limited Liability Act and 1862 Companies Act.
OG invested in risky assets (such as railways) which then
failed. Company itself was both illiquid and insolvent in 1866.
Other banks and businesses then failed in turn. The Bank
Charter Act (1844) was suspended to allow unlimited issue of
additional notes.
19
Bank runs: (ii) Northern Rock
NR was a building society (mutual savings and mortgage
institution) which de-mutualised in 1998 to become a bank.
Rapid growth of mortgage loan book (23% per year), financed
partly by short-term loans (ABCP).
On 9 Aug 2007 the international ABCP market collapsed, and
Northern Rock could not roll over loans.
From 14 Aug 2007 to 14 Sep 2007 the Bank of England and
FSA tried to resolve the situation secretly.
When the problem (and lack of solution) became public
depositors panicked and withdrew funds.
20
Source: Shin (2009)
21
Commercial Paper: Volume
Source: Kacperczyk & Schnabl, JEP (2010)
22
Commercial Paper: Volume
Source: Kacperczyk & Schnabl, JEP (2010)
23
What sort of run was it?
Northern Rock was involved in maturity transformation
(borrowing short term and lending mortgages for 25 years).
A large part of its funds came from other banks via ABCP.
When the market for ABCP stopped (due to problems
elsewhere) NR could not obtain new funds.
Depositors only queued up to withdraw their money one
month after the crisis and they withdrew less funds than
was lost via ABCP.
24
Hyun Song Shin (2008) “Reflections on Modern Bank Runs:
A Case Study of Northern Rock” Princeton University, mimeo.
25
Bank runs: (iii) Money Market Mutual Funds
As a consequence of the collapse of Lehmann Brothers, a
bank run started in September 2008 (nb one year after
Northern Rock).
This run was a run on institutions that are not officially
banks and involved the shadow banking system.
Dramatis personae:
Money market mutual funds
Asset backed commercial paper
Conduits (= Structured Investment Vehicles)
26
Money Market Mutual Funds
A strange type of mutual fund where the value of a share is
meant to be kept to $1 (only in USA).
If a MMMF announces a prices less than $1, it is called
“breaking the buck”.
MMMFs pay dividends (from interest earned less expenses):
return aims to be slightly higher than on a deposit account.
Allowed under the Security and Exchange Commission Act of
1940, rule 2a-7, which limits the assets that can be held.
27
Money Market Mutual Funds: investment rules
under SEC Act (1940) rule 2a-7
Only invest in “very good quality” bonds and ABCP.
Underlying assets are low risk.
Maximum 5% of fund in any asset type.
Diversified portfolio reduces the risk still further.
Maturity of assets: maximum term is 13 months; average term
less than 60 days.
Short-term lending safer than long-term lending.
28
Conduits = Structured Investment Vehicles (SIVs)
Maturity transformation:
Purchase assets of long-duration (eg CDOs).
Raise money through short-term borrowing (eg 30 days).
This means that every 30 days the conduit must repay its
creditors and it can only do this by borrowing again. This is
called “rolling over” the debt.
Separate legal entity (no physical existence): not on balance
sheet of originating firm. A conduit is a SPV.
29
Typical structure of a Conduit (Structured Investment
Vehicle)
30
Structured Investment Vehicles / Conduit
A conduit is really just a bank (non-retail)
The advantage to the originator is that the SIV is off the balance
sheet (we shall discuss this tomorrow).
The disadvantage to the originator is that it must provide
credibility to the conduit:
Formal: “retained interest” originator has financial stake
Informal: if conduit fails then originator loses reputation
Conduits’ raised money largely from MMMFs.
31
The crisis of September 2008 (nb not 2007)
15 Sep 2008: Lehman Brothers collapsed.
16 Sep 2008: Reserve Primary MMMF suffered large losses on
paper issued by LB and “broke the buck” (value fell from $1 to
¢97).
17 Sep 2008 Total funds invested in MMMFs were $3.4 trillion.
5% of funds = $170 billion are withdrawn in one day.
18 Sep 2008 US Treasury announces that losses on MMMFs
guaranteed up to $50 billion.
Effectively extends deposit insurance to part of shadow
banking system.
32
Final comments on Diamond-Dybvig Model
The UK did not have deposit insurance until required to do so
by the European Union in 1980 and even then the amount
insured was small.
The DD model applies to banks which are solvent, but
Overend-Gurney and Lehman Brothers were insolvent and
Northern Rock’s solvency was questionable at the time of the
run.
33
Extending the D-D Model
D-D model is too simple because it does not describe the
details of a bank’s balance sheet.
Ignores the composition of the liabilities (ie where did the
money come from).
In reality, a bank’s assets are not shared out equally: there are
complicated rules about sharing assets between suppliers of
funds.
34
What you should do now
Go over your lecture notes to check that you understand
them. Do this tonight and ask questions tomorrow.
Look on the website to find the reading material (nearly all is
online):
Shin’s article is on the web at his Princeton homepage
(google the title).
There is a powerpoint presentation in Italian by Napoli,
Ilarid, Soardo “Riflessioni su NorthernRock: la corsa agli
sportelli che annunciò la crisi finanziaria globale”