DOCSLIB.ORG

Bank Runs and Private Remedies

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Bank Runs and Private Remedies 43 Gerald P. Dwyer, Jr. and R. Alton Gilbert Gerald P. Dwyer, Jr., a professor of economics at Clemson University, is a visiting scholar and R. Alton Gilbert is an assistant vice president at the Federal Reserve Bank of St. Louis. Erik A. Hess and Kevin L. Kliesen provided research assistance. Bank Runs and Private Remedies URRENT banking regulation in the United lessened their impact. These private remedies States is based in part on the notion that both did not solve the problem of runs, but they did the banking system and the economy must be mitigate the effects of the runs on the banks protected from the adverse effects of bank and the economy. In this article, we explain the runs. An example often cited as typical is the private remedies for runs and provide some string of bank runs from 1930 to 1933, which evidence on the frequency and severity of runs conventional wisdom holds responsible for on the banking system. thousands of bank failures and the Banking Holiday of 1933 when all banks closed. The BANK RUN’S: THE THEORY runs on savings associations in Ohio and Mary- land in 1985 are more recent examples. Before examining the history of bank runs, it This conventional view is reflected in a recent is useful to consider why banks at-c vulnerable comment on the “Panic of 1907” in the Wall to runs. This examination establishes a frame- Street Journal (1989): work for determining the kinds of observations that would be consistent with their occurrence. Long lines of depositors outside the closed doors of their banks signaled yet another financial crisis, Runs on Individual Banks an all-too familiar event around the turn of the century. In a run, depositors attempt to withdraw cur- rency from a bank because they think the bank Research in the last few years on bank runs will not continue to honor its commitment to indicates that the conventional view is mistaken. pay on demand a dollar of currency for a dollar Runs on the banking system were not common- of deposits.’ One aspect of the contract banks place events, and their impact on depositors and make with their customers is central to under- the economy easily can be overstated. Prior to standing why depositors would run on their the formation of the Federal Reserve System in bank. Banks make contractual promises that 1914, banks responded to runs in %vays that they cannot always honor: exchange of gold or ‘Salant (1983) provides a general analysis of the break- liabilities at par. The mapping from speculative attacks into down of such arrangements as bank redemption of its bank runs is discussed by Flood and Garber (1982). MAY/JUNE 1SBE 44 currency at par value for bank liabilities.’ When The effects of a run by depositors on one banks issued notes as a form of currency, the bank can be illustrated by an example. Table 1 promise was a contractual agreement to deliver shows the balance sheet of a hypothetical na- specie (gold or silver) in exchange for the bank’s tional bank in New York City in the national notes at par value. Banks currently promise to banking period (1863 to 1914). Its liabilities in- deliver U.S. currency to depositors on demand clude deposits and national bank notes backed at par value. Because banks hold reserves that by securities deposited with the Treasury. In are only a fraction of their liabilities payable on the event of the bank’s failure, the notes were demand, they cannot honor this promise if all guaranteed by the U.S. Treasury, whether or of their depositors try to convert deposits into not the deposited bonds were sufficient backing currency at the same time. for the notes. Apparently as a result of this Fractional-reserve banking by itself is not suf- guarantee, runs on banks in the national bank- ficient to make it impossible for banks to honor ing era were runs by depositors, not by note their promises to deliver currency in exchange holders.’ for deposits on demand. Banks always could During tlus period, national banks in New honor a promise to pay currency at a variable York City were required to maintain reserves of exchange rate of currency for deposits. If all specie and legal tender equal to 25 percent or depositors want to exchange their deposits for more of deposits, with the required ratio of currency at the same time, banks do not have reserves to deposits lower for national banks in sufficient currency (or’ other reserves that can other cities. Banks generally held excess re- be transformed into currency on a dollar-for- serves as a buffer stock to meet deposit with- dollar basis instantaneously) to meet that de- drawals, but we use a reserve ratio of 25 per- mand for currency at a price of one dollar of cent to keep the numerical example simple. ‘l’he currency for one dollar of deposits.’ second part of table I shows the initial loss of in the normal course of affairs, the inability reserves upon withdrawal of $2 million of of all depositors to exchange their deposits for deposits, while the last part indicates the reac- currency is irrelevant. As some depositors with- tion of the bank to the decrease in deposits. An draw currency from a bank, others deposit it. individual bank can replenish its reserves by The low probability of every depositor closing selling assets; in the example, the bank returns his or her account at the same time is the its reserve ratio to 25 pci-cent by selling $1.5 reason a bank usually can operate with frac- million in assets. At least part of the reserves tional reserves and pay currency on a dollar- are from other banks, thereby transmitting the for-dollar basis. reserve loss to other banks. A low probability is not the same as a zero In a i-un on a single bank, the specie and legal probability though. Information or rumors tender withdrawn from the bank are likely to which suggest a capital loss by a bank may in- be largely deposited in other banks. As a result, duce its depositors to attempt to convert their 4 a run on a single bank is not likely to drain deposits to currency. The mere expectation reserves from the banking system or increase that other depositors will attempt the same con- currency held by the public. If the currency version also can cause a run on a hank. A run withdrawn is deposited in other banks, the net on a single bank is unlikely, however, to have effect on the bank’s balance sheet is that shown substantial effects on the economy. The primary in table 1, and the deposit and reserve loss at effect of a single bank closing is that the bank this bank is matched by a similar’ increase in winds up its affairs and no longer operates. deposits and reserves at other banks. ‘Whether this promise is a result of market forces or While default generally is not the expected outcome of a government regulation is an open question. Davis (1910) contract, it does happen. 4 summarizes the laws in the United States in the 19th cen- Among others, Diamond and Dybvig (1983) and Gorton tury, and Schweikart (1987) provides the historical devel- (1985a) present models of runs. opment of these laws in the South in the 19th century. 5 In banking panics prior to the national banking era, ‘Promises that cannot be kept in all states of the world are hardly unique to banking. For instance, firms often cannot customers of banks attempted to redeem their bank notes for specie. For details on the backing for notes in the na- make payments on debt if there is a large decrease in the tional banking era, see Friedman and Schwartz (1963), pp. demand for their products. The common legal word for 20-23, 781-82. failure to honor contractual commitments is “default.” FEDERAL RESERVE BANK OF St LLU-tS 45 N’ ,,, ‘ Tabiel ,, N BaI~à$beet*1 a t4~tIonaIBank In New York CityWith a Large Nw8thdtawai of*wo (mi1Iion~of dollars) 1uthAl~BAIAN* ~HEE? Assets N LisF~dtt1es 5 DØ)~OSS *09 tsØsf$rtd*) Nota I 0 ,n*ssn~itig~a$S~ “I~te , ,N~t~vorth , \zs Ssásets~ “s” “ Totstiiabthtes’ $36 ‘~~MMS!S~. tfl$aRA~~$2~tUOMS\p~, NN Assets N -\ ~“ N N “ NN V ~‘N\~tGtVSt\ ~N\ ,~ N’ , ~poS $80 N N,, N’,N Sti~s ‘‘N N$wt’, NN N Tawlla~lnttes N Afl~NEsTOSXtK*’ÔP RESE~W~!$AT1o ‘ton ~ACENT N NN~N :“ N UIbilttes 4fl N NotesD~posi$ N\M$rN ~$SSN t4wfl 25 NN \‘N tIS T1a~brfrtt~S $14 N Runs on the Banking System term that has a connotation of unreasoning fear or hysteria. Contagious runs, however, can be Runs on a single bank can develop into runs 6 based on the optimal use of all information by on the banking system. An important, if seem- all agents. As a simple example, suppose that ingly obvious, aspect of banking is that the like- two banks are identical in all respects known lihood of a bank’s default on its deposit agree- by depositors, and one of the two fails because ment is not known with certainty by depositors. of loan losses. Because of the first failure, de- Instead, depositors estimate this likelihood as best they can with available information. One positors will increase their estimate of the pro- type of information that can be useful in bability that the second bank will fail.
Load more

Recommended publications
  • Uncertainty and Hyperinflation: European Inflation Dynamics After World War I
    FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Uncertainty and Hyperinflation: European Inflation Dynamics after World War I Jose A. Lopez Federal Reserve Bank of San Francisco Kris James Mitchener Santa Clara University CAGE, CEPR, CES-ifo & NBER June 2018 Working Paper 2018-06 https://www.frbsf.org/economic-research/publications/working-papers/2018/06/ Suggested citation: Lopez, Jose A., Kris James Mitchener. 2018. “Uncertainty and Hyperinflation: European Inflation Dynamics after World War I,” Federal Reserve Bank of San Francisco Working Paper 2018-06. https://doi.org/10.24148/wp2018-06 The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Uncertainty and Hyperinflation: European Inflation Dynamics after World War I Jose A. Lopez Federal Reserve Bank of San Francisco Kris James Mitchener Santa Clara University CAGE, CEPR, CES-ifo & NBER* May 9, 2018 ABSTRACT. Fiscal deficits, elevated debt-to-GDP ratios, and high inflation rates suggest hyperinflation could have potentially emerged in many European countries after World War I. We demonstrate that economic policy uncertainty was instrumental in pushing a subset of European countries into hyperinflation shortly after the end of the war. Germany, Austria, Poland, and Hungary (GAPH) suffered from frequent uncertainty shocks – and correspondingly high levels of uncertainty – caused by protracted political negotiations over reparations payments, the apportionment of the Austro-Hungarian debt, and border disputes. In contrast, other European countries exhibited lower levels of measured uncertainty between 1919 and 1925, allowing them more capacity with which to implement credible commitments to their fiscal and monetary policies.
    [Show full text]
  • 12. the Recent Crisis – and Recovery – of the Argentine Economy: Some Elements and Background
    12. The Recent Crisis – and Recovery – of the Argentine Economy: Some Elements and Background Arturo O’Connell ______________________________________________________________ INTRODUCTION The Argentine crisis could be examined as one more crisis of the developing countries – admittedly a star pupil that had received praise from many sides – hit by the vagaries of the international financial markets and/or its own policy mistakes. To a great extent that is a line of argument that could provide some illumination. However, it could be even more interesting to examine the peculiarities of the Argentine experience – always in that general context –that have made it such an intractable case for normal medication. Not only would it be best to pin down those peculiarities and their consequences, but also it is necessary to understand that they were not just a result of the eccentricities of some people in some far-off Southern end of the world. Finance, both external and domestic, is one essential part of the story. Argentina became one of the most highly liberalized financial systems in the world. Capital could freely flow in and out without even clear registration demands; big firms profited from such a system by being able to finance themselves – at cheaper financial costs – in the international market at the same time that wealthy families chose to hold a significant proportion of their liquid assets abroad. The domestic banking system was opened to foreign entry to the point of not requiring the habitual reciprocity with third countries and a large and increasing proportion of the operations became denominated in foreign currency. To build up confidence in the local currency a hard peg to the US dollar was instituted by law rather than by Executive Order and the Central Bank became a mere currency board issuing currency at the legally determined rate only against foreign exchange.
    [Show full text]
  • JP Morgan and the Money Trust
    FEDERAL RESERVE BANK OF ST. LOUIS ECONOMIC EDUCATION The Panic of 1907: J.P. Morgan and the Money Trust Lesson Author Mary Fuchs Standards and Benchmarks (see page 47) Lesson Description The Panic of 1907 was a financial crisis set off by a series of bad banking decisions and a frenzy of withdrawals caused by public distrust of the banking system. J.P. Morgan, along with other wealthy Wall Street bankers, loaned their own funds to save the coun- try from a severe financial crisis. But what happens when a single man, or small group of men, have the power to control the finances of a country? In this lesson, students will learn about the Panic of 1907 and the measures Morgan used to finance and save the major banks and trust companies. Students will also practice close reading to analyze texts from the Pujo hearings, newspapers, and reactionary articles to develop an evidence- based argument about whether or not a money trust—a Morgan-led cartel—existed. Grade Level 10-12 Concepts Bank run Bank panic Cartel Central bank Liquidity Money trust Monopoly Sherman Antitrust Act Trust ©2015, Federal Reserve Bank of St. Louis. Permission is granted to reprint or photocopy this lesson in its entirety for educational purposes, provided the user credits the Federal Reserve Bank of St. Louis, www.stlouisfed.org/education. 1 Lesson Plan The Panic of 1907: J.P. Morgan and the Money Trust Time Required 100-120 minutes Compelling Question What did J.P. Morgan have to do with the founding of the Federal Reserve? Objectives Students will • define bank run, bank panic, monopoly, central bank, cartel, and liquidity; • explain the Panic of 1907 and the events leading up to the panic; • analyze the Sherman Antitrust Act; • explain how monopolies worked in the early 20th-century banking industry; • develop an evidence-based argument about whether or not a money trust—a Morgan-led cartel—existed • explain how J.P.
    [Show full text]
  • Global European Banks and the Financial Crisis
    Global European Banks and the Financial Crisis Bryan Noeth and Rajdeep Sengupta This paper reviews some of the recent studies on international capital flows with a focus on the role of European global banks. It presents a revision to the commonly held “global saving glut” view that East Asian economies (along with oil-rich nations) were the dominant suppliers of capital that fueled the asset price boom in many parts of the world in the early 2000s. It argues that the role of funding costs and a “liberal” regulatory regime that allowed for an unprecedented expansion of the balance sheets of European banks was no less important. Finally, we describe the aftermath of the crisis in terms of some of the challenges faced by Europe as a whole and European banks in particular. (JEL F32, G15, G21, E44) Federal Reserve Bank of St. Louis Review , November/December 2012, 94 (6), pp. 457-79. significant economic slowdown currently plagues the world economy, especially the countries in Europe. This slowdown comes in the aftermath of what has been widely A regarded as an ongoing global financial turmoil that has spanned the past half decade (2007-12). The economic woes are especially severe in the euro zone, where countries battle not only an economic recession, but also asset price deflation and a burgeoning debt crisis. 1 Given the enormity of the economic crisis in the euro zone and the length and breadth of its impact, different studies have emphasized different aspects of the crisis. This paper presents a brief overview of the role played by global finance in the crisis in the euro zone.
    [Show full text]
  • Friday, June 21, 2013 the Failures That Ignited America's Financial
    Friday, June 21, 2013 The Failures that Ignited America’s Financial Panics: A Clinical Survey Hugh Rockoff Department of Economics Rutgers University, 75 Hamilton Street New Brunswick NJ 08901 [email protected] Preliminary. Please do not cite without permission. 1 Abstract This paper surveys the key failures that ignited the major peacetime financial panics in the United States, beginning with the Panic of 1819 and ending with the Panic of 2008. In a few cases panics were triggered by the failure of a single firm, but typically panics resulted from a cluster of failures. In every case “shadow banks” were the source of the panic or a prominent member of the cluster. The firms that failed had excellent reputations prior to their failure. But they had made long-term investments concentrated in one sector of the economy, and financed those investments with short-term liabilities. Real estate, canals and railroads (real estate at one remove), mining, and cotton were the major problems. The panic of 2008, at least in these ways, was a repetition of earlier panics in the United States. 2 “Such accidental events are of the most various nature: a bad harvest, an apprehension of foreign invasion, the sudden failure of a great firm which everybody trusted, and many other similar events, have all caused a sudden demand for cash” (Walter Bagehot 1924 [1873], 118). 1. The Role of Famous Failures1 The failure of a famous financial firm features prominently in the narrative histories of most U.S. financial panics.2 In this respect the most recent panic is typical: Lehman brothers failed on September 15, 2008: and … all hell broke loose.
    [Show full text]
  • Financial Catastrophe Research & Stress Test Scenarios
    Cambridge Judge Business School Centre for Risk Studies 7th Risk Summit Research Showcase Financial Catastrophe Research & Stress Test Scenarios Dr Andy Skelton Research Associate, Cambridge Centre for Risk Studies 20 June 2016 Cambridge, UK Financial Catastrophe Research 1. Catalogue of historical financial events 2. Development of stress test scenarios 3. Understanding contagion processes in financial networks (eg, interbank loans) - Network models & visualisations - Role of central banks in financial crises - Practitioner model – scoping exercise 2 Learning from History Financial systems and transaction technologies have changed But principles of credit cycles, human trust and financial interrelationships that trigger crises remain relevant 12 Historical Financial Crisis Crises occur periodically – Different causes and severities – Every 8 years on average – $0.5 Tn of lost annual economic output – 1% of global economic output Without FinCat global growth could be 4% a year instead of 3% Financial catastrophes are the single greatest economic risk for society – We need to understand them better 3 Historical Severities of Crashes – Past 200 Years US Stock Market Crashes UK Stock Market Crashes 1845 Railway Mania… 1845 Railway Mania… 1997 Asian Crisis 1997 Asian Crisis 1866 Collapse of Overend… 1866 Collapse of Overend… 1825 Latin American Crisis 1825 Latin American Crisis 1983 Latin American Debt… 1983 Latin American Debt… 1837 Cotton Crisis 1837 Cotton Crisis 1857 Railroad Mania… 1857 Railroad Mania… 1907 Knickerbocker 1907 Knickerbocker
    [Show full text]
  • The Many Panics of 1837 People, Politics, and the Creation of a Transatlantic Financial Crisis
    The Many Panics of 1837 People, Politics, and the Creation of a Transatlantic Financial Crisis In the spring of 1837, people panicked as financial and economic uncer- tainty spread within and between New York, New Orleans, and London. Although the period of panic would dramatically influence political, cultural, and social history, those who panicked sought to erase from history their experiences of one of America’s worst early financial crises. The Many Panics of 1837 reconstructs the period between March and May 1837 in order to make arguments about the national boundaries of history, the role of information in the economy, the personal and local nature of national and international events, the origins and dissemination of economic ideas, and most importantly, what actually happened in 1837. This riveting transatlantic cultural history, based on archival research on two continents, reveals how people transformed their experiences of financial crisis into the “Panic of 1837,” a single event that would serve as a turning point in American history and an early inspiration for business cycle theory. Jessica M. Lepler is an assistant professor of history at the University of New Hampshire. The Society of American Historians awarded her Brandeis University doctoral dissertation, “1837: Anatomy of a Panic,” the 2008 Allan Nevins Prize. She has been the recipient of a Hench Post-Dissertation Fellowship from the American Antiquarian Society, a Dissertation Fellowship from the Library Company of Philadelphia’s Program in Early American Economy and Society, a John E. Rovensky Dissertation Fellowship in Business History, and a Jacob K. Javits Fellowship from the U.S.
    [Show full text]
  • Recurring Storms: Weathering the Future by Understanding the Past
    The Global Business Law Review Volume 1 Issue 1 Article 4 2010 Recurring Storms: Weathering the Future by Understanding the Past Robert L. Brown Ph.D. Greenebaum, Doll & McDonald Follow this and additional works at: https://engagedscholarship.csuohio.edu/gblr Part of the Banking and Finance Law Commons, and the International Trade Law Commons How does access to this work benefit ou?y Let us know! Recommended Citation Robert L. Brown Ph.D., Recurring Storms: Weathering the Future by Understanding the Past , 1 Global Bus. L. Rev. 1 (2010) available at https://engagedscholarship.csuohio.edu/gblr/vol1/iss1/4 This Article is brought to you for free and open access by the Journals at EngagedScholarship@CSU. It has been accepted for inclusion in The Global Business Law Review by an authorized editor of EngagedScholarship@CSU. For more information, please contact [email protected]. RECURRING STORMS: WEATHERING THE FUTURE BY UNDERSTANDING THE PAST ROBERT L. BROWN I. TULIPMANIA 1637 ................................................................... 2 A. Boom................................................................................ 2 B. Bust .................................................................................. 3 C. Aftermath ......................................................................... 3 D. Summary .......................................................................... 4 II. MISSISSIPPI SCHEME 1720 ....................................................... 4 A. Boom...............................................................................
    [Show full text]
  • Human Behavior and the Panic of 1907
    12/19/2017 Human Behavior And The Panic Of 1907 News Categories About Us VALUE INVESTING Tools Timeless Reading Books Letters Search … Human Behavior And The Panic Of 1907 By John Huber • on December 18, 2017 6:00 pm • in Value Investing I recently wrote a post about a book I really liked called America’s Bank, by Roger Lowenstein. The book talks about the formation of the Federal Reserve, and the events that led to it. One of the major catalysts that started the process of banking reform was the Panic of 1907. On a related note, Seth Klarman’s favorite books include everything by Roger Lowenstein Get The Timeless RECENT POSTS Reading eBook in PDF / MORE NEWS Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your How Articial Intelligence Is colleagues. Charting The Future For Mobile http://www.valuewalk.com/2017/12/human-behavior-panic-1907/ 1/9 12/19/2017 Human Behavior And The Panic Of 1907 email address Payments GET THE PDF Why AI Could Be Entering A Golden Age Richard Thaler: “I Have More Faith In Mankind Than Economists Do” Think This Is The Longest Bull Market Ever? Not Yet Ecient Markets …. Right Move Over AI And Machine Learning, Quantum Computing Is The Real Game Changer Mohnish Pabrai On Philanthropy And Investing Chemical Activity Accelerating…if it holds, we aren’t even close to the end of the rising market schlappohr / Pixabay What Caused the Panic of 1907? http://www.valuewalk.com/2017/12/human-behavior-panic-1907/ 2/9 12/19/2017 Human Behavior And The Panic Of 1907 Basically, the Panic of 1907 was caused by a classic run on the bank, leading to the failure of the Knickerbocker Trust company in New York, which drained cash reserves from the nancial system and created a shortage of liquidity all over the city and eventually in the broader economy.
    [Show full text]
  • Preventing Bank Runs
    Economic Brief March 2018, EB18-03 Preventing Bank Runs By Renee Haltom and Bruno Sultanum Banking can be defined as the business of maturity transformation, or “borrowing short to lend long.” Economists and policymakers have long viewed banking as inherently unstable, that is, prone to runs. This Economic Brief reviews the intuition and theory behind bank runs and the most popular proposed solutions. It also explores new research suggesting that runs might be prevented by creating a new, low-cost type of deposit contract that eliminates the incentive to run. Banking can be defined as the business of matu- crisis as having resembled a traditional bank run rity transformation, or “borrowing short to lend across many markets.1 Given the potential costs long.” For example, commercial banks take de- of runs, preventing them is of interest to policy- posits from households and businesses — short- makers and the general public. term liabilities that depositors can withdraw on demand — and use them to make longer-term This Economic Brief reviews the basic theory of loans to other households and businesses. runs and describes how the economics profes- Banking activity does not take place only within sion has explored potential solutions. It also pres- commercial banks; entities ranging from money ents a new solution proposed in a recent model market mutual funds to investment banks per- by one author of this brief (Sultanum) along with form this bank-like function in what has become David Andolfatto of the St. Louis Fed and Ed known as the “shadow-banking” sector. Nosal of the Atlanta Fed.
    [Show full text]
  • Global Financial Crisis: a Minskyan Interpretation of the Causes, the Fed’S Bailout, and the Future
    Working Paper No. 711 Global Financial Crisis: A Minskyan Interpretation of the Causes, the Fed’s Bailout, and the Future by L. Randall Wray Levy Economics Institute of Bard College March 2012 *This paper reports research undertaken as part of a Ford Foundation project, “A Research And Policy Dialogue Project On Improving Governance Of The Government Safety Net In Financial Crisis.” The author thanks June Carbone for comments and Andy Felkerson and Nicola Matthews for assistance. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2012 All rights reserved ISSN 1547-366X ABSTRACT This paper provides a quick review of the causes of the Global Financial Crisis that began in 2007. There were many contributing factors, but among the most important were rising inequality and stagnant incomes for most American workers, growing private sector debt in the United States and many other countries, financialization of the global economy (itself a very complex process), deregulation and desupervision of financial institutions, and overly tight fiscal policy in many nations.
    [Show full text]
  • Financial Crises and the 2008 Meltdown
    BANK RUNS, FINANCIAL CRISES AND THE 2008 MELTDOWN Cesar E. Tamayo Money and Banking Rutgers University August 3 rd , 2011 BANK RUNS MECHANICS OF BANK RUNS (DIAMOND-DYBVIG) • During a bank run, depositors rush to withdraw their deposits because they expect the bank to fail. • In fact, the sudden withdrawals can force the bank to liquidate many of its assets at a loss and to fail • During a panic with many bank failures, there is a disruption of the monetary system and a reduction in production. MECHANICS OF BANK RUNS (DIAMOND-DYBVIG) • Uninsured demand deposit contracts are able to provide liquidity, but leave banks vulnerable to runs. • This vulnerability occurs because there are multiple equilibria with differing levels of confidence: • High level of confidence no run (“good” equilibrium) • Low level of confidence bank run (“bad” equilibrium) TYPES OF BANK RUNS • There are mainly three types of bank runs, depending on what depositors do with the withdrawn funds. • Type 1: depositors redeposit their funds in banks that they perceive as safe(r). • Type 2: depositors buy safer assets like US Treasury bills (“flight to quality”) and whoever sells the T-bills deposits this money in the financial system. • Types 1 and 2 pose a risk to individual institutions but limited economy-wide risks. • Type 3: depositors keep their money outside the financial system. BANKING CRISIS BANK FAILURES BANK FAILURES AND WELFARE The Five Big Five Crises : Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992), where the starting year is in parenthesis FINANCIAL CRISES: BEYOND BANKING CRISES • Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures.
    [Show full text]