Friday, October 14, 2022

Nobels and financial crises

 (At National Review)

What This Year’s Nobel Economists Can Teach Us about Financial Crises

This week, economists are celebrating the Nobel Prize given to Ben Bernanke, Doug Diamond and Phil Dybvig for their work on banking.

Bernanke pointed out that banks matter. In the Great Depression, banks failed, and there was nobody left who knew how to make new loans. The economy contracted, not just for lack of money or for animal spirits of investors, but for lack of credit. Diamond and Dybvig wrote the classic economic model of bank runs, which shows how banks can fail even when they are “illiquid” rather than “insolvent.” The logic works like this: The bank has invested our money in illiquid projects, so if I suspect others are going to run to get their money out, I run to get mine out first before it’s all gone. 

But it is no insult to say that these are not eternal verities. The papers were written about 40 years ago. Each was the launching pad for a vast and important investigation. Indeed, Nobel Prizes largely recognize that sort of lasting influence on subsequent work. But that subsequent investigation opens new possibilities. Newton is no less profound for having been followed by Einstein. Each also sought to understand the world as it was, which is how one should start. But there are other possibilities for how the world might be — and how it might be better. 

Economics might seem obvious. George Bailey and Michael Banks understood bank runs, didn’t they? Economic analysis lets us see all the ingredients that a banking crisis needs, and therefore how they might be avoided. Bank failure and bank runs are actually fragile phenomena. A lot has to go wrong. There are lots of ways to fix them [i.e. not just bailouts and deposit insurance]. 

Bankruptcy does not mean a giant crater where there once was a bank. It means reorganization. Stockholders and creditors lose money, and valuable operations continue under new management. Why, if the Farmers and Mechanics bank of Nowhere Nebraska failed in the Great Depression, did Chase or Citi not swoop in, buy the assets at a discount, and keep employed the people that Bernanke pointed out had unique and detailed knowledge of how to make profitable loans? Because interstate and branch banking was illegal. Banks could not list stock on exchanges, and had to find new capital from local businesspeople, whose businesses were failing. But all that has changed.

Diamond and Dybvig’s 1983 article, being a beautiful essay in economic theory, is even more stark. As you read the article, you will be struck by the number of assumptions needed to get a bank run going. Each is necessary. If people are lining up to get money out, why does the bank not borrow against its valuable illiquid assets? Before the Fed, clearinghouses were set up just for this purpose. Why does the bank not issue additional equity? Why can’t the bank sell loans, rather than accept half-built houses that it does not know how to finish? Why doesn’t the bank get money to invest by issuing floating-value securities instead of first-come-first-serve deposits? Why not  suspend payments? All of these channels and more must be turned off to get a bank run going. Showing clearly just what it takes to get a run going is Diamond and Dybvig’s masterful insight. 

Diamond and Dybvig showed how deposit insurance, the expedient implemented in the 1930s, could stop bank runs. If the government stands behind deposits, there is no need to run, One concludes more generally that government as a lender of last resort, creditor bailouts, and government recapitalization can stop crises, as Bernanke showed personally in 2008. 

But do not conclude that these are the only, or best ways to stop financial crises. [They didn't say that.] Moreover, deposit insurance and bailouts stop a crisis once it is happening. But they lead to too much risk-taking by financial institutions, and by depositors who know they don’t have to worry about the bank’s investments. We need a better system. 

The current patch is to have regulators try to keep banks from taking too many risks. But we have seen that mechanism fail over and over again. Regulators failed to see mortgages build up; they failed to see that Greek debt might not be so hot for banks to hold; they failed to “stress test” a pandemic, leading to a second massive bailout; they failed to see the possibility of an energy price increase. They didn’t even fix money-market funds, bailed out again in 2020, and the simplest to fix. Last week, we saw that U.K. regulators failed to see plain-vanilla leverage in pension funds. We shall soon see who else is exposed to sharp interest-rate rises in ways that the regulators have not foreseen. 

The model — allow lots of run-prone assets, stop runs with deposit insurance and bailouts, stop risk-taking with regulation — has run its course. The next bailout will be so big, it is questionable that our governments can do it without major inflation or sovereign-credit stress. 

It’s time for another idea from the 1930s, and analyzed in the 2000s with the kinds of contemporary tools our Nobelists brought forth: Banks should fund risky investments by issuing equity, now extremely liquid. Run-prone securities like deposits should be backed 100 percent by reserves or short-term Treasury securities. (Details in "Toward a Run-Free Financial System.")

It’s a simple model; it requires next to no regulation; and we can end private financial crises forever. (“Private” because sovereign debt is another matter, and another sort of crisis.) Bernanke, Diamond, and Dybvig’s work paved the way for this current insight. We can appreciate their analysis without setting in stone the solutions that they analyzed, which were largely just the ones that had already been settled on by previous political decisions. 




  1. Brilliant! Very clear, balanced with policy solution. Thank you.

  2. I always found the DD model somewhat confusing to be honest. Isn't a bank run simply an example of what happens when there are price controls? Breadlines in communist countries, gas lines in the 70s, queues in front of a bank, etc., etc.? Different goods, but the same underlying economic logic. Why the need for a special model for banking?

  3. But they lead to too much risk-taking by financial institutions. This is a nonsensical statement; do you really think bankers say in taking on risk no worry as the gov will bail us out? Loan officers for sure never think that and yes, incentive system might have any particular lending person make a more risky loan, but no senior bank officers think to themselves that take on lots of risk, no worry as Gov will bail us out.
    Insurance industry model separates the premium collecting biz from the risk taking at the Hold-Co level. Been around for look time and has worked quite well in distressed situations. Just separate risk taking from deposit taking in banks would do the trick and if at Hold-Co level banks want to take risks, so be it. Failure and the deposit taking sub is sold off.

    1. Theres a famous paper by Kariken and Wallace going over moral hazard via deposit insurance.

    2. The point raised by John isn't about loan officers giving risky loans. It's about banks getting funded by debt rather than equity. And, yes, banks are over-leveraged, so the statement is not "nonsensical".

  4. The 2014 paper is interesting for the fact that an avowed right-libertarian penned it.
    E.g., in the Conclusion, we find "For example, a simple, clear regulation is this: nobody but the Treasury may issue short-term, fixed-value, first-come-first-served, I'm-bankrupt-if-I-can't-pay-debt."

    This is not a criticism -- simply an observation.

    In essence, a bank that cannot borrow in order to lend is simply an asset manager or a trust company. The firm that borrows from such a bank has to back the loan 100% with short-term government assets. Ergo, no business needing seasonal working capital will be able to borrow from such banks, and its cost of funds will increase proportionately to the amount of seasonal working capital it requires. Where will that leave the economy?

    We will have to step back into the era of Bills of Exchange for financing working capital. The banking sector cannot provide that financing, according to the article's proposals because a bill of exchange is not guaranteed against dishonour. Ergo, the banking sector no longer acts as an intermediator in the origination and trading of credit, and the availability of credit contracts.

    At the same time, the FRB becomes redundant. If banks can't experience a run, then there is no purpose that the FRB can assume that will make its existence certain.

    If securities cannot be hypothecated, then holding financial securities is uneconomic. The action moves to making markets in bills of exchange which can be hypothecated. However, the cost of information increases substantially. Ergo, the real rate of return is positive and high.

    Bottom-line: One cannot escape the conclusion that the 2014 article is an argument that the strong- (and to a lesser degree) the semi-strong- efficient markets hypotheses are invalid.

  5. "The other great cost of these post-crisis policies is the intrusion of the Fed into politics and fiscal policy. Mr. Bernanke has helped to finance an historic federal borrowing binge while disguising its future costs. The bill for that borrowing will only become clear to taxpayers when interest rates rise. Mr. Bernanke has also made the Fed a political adjunct of the Treasury on regulation and even on taxes and spending, which has compromised its independence.

    "This may be the largest risk for the future, especially when the Fed must raise interest rates." Editorial -- The Wall Street Journal, 2014, on the legacy of B. Bernanke as he is about to preside over the FOMC he will as FRB chairman.

    The Editorial Board appears to have had the prescience of perfect foresight when these were printed in the original.

  6. Bernanke was a hero IMO. Sterilization worked, paying IoR , preventing terrible inflation back then. Robert Frank from Cornell wrote a great chapter about him in "Success and Luck." While Sowell should have gotten it, Ben isn't a bad choice. It's well-deserved.

  7. DisgustedwithElitismOctober 17, 2022 at 6:25 AM

    "Under this process, the Fed enters the market to buy securities, typically mortgage-backed securities (MBS) and Treasuries, injecting both capital and liquidity into the market. ...

    As of August 3, the Fed’s assets stand at $8.9 trillion.

    from "Tracker: The Federal Reserve’s Balance Sheet Assets" (www. americanactionforum. org/ insight/ tracker-the-federal-reserves-balance-sheet/#ixzz7cUz9cqCE)

    Just prior to the onset of the Financial Crisis of 2008-2009, the balance sheet of the FRB stood at $995B. In the last 14 years, the FRB increased M1 by $8T, in particular by buying MBS. Further, the FOMC kept interest rates at historically low levels for more than a decade. Between excessive injections of cash and low interest rates, the wealth gap that so many bemoan was enabled by the FRB and its complicit supporters in the political class. It is worthy of note the FRB purchased MBS, the securities that caused the FC '08/'09 (with others), thereby juicing a housing market already benefitting from extraordinarily low rates. Washington, D.C., was busily laying the foundation for the inflation that afflicts the USA, and the world today.

    All it took were the excesses of the COVID-19 pandemic and the Biden administration to tip it all over the edge.

    "As a result of the stock market crash and global economic collapse caused by the covid pandemic in early 2020, the Fed aggressively increased the money supply by nearly 40%, more than double the money supply increases in prior recessions..."

    from "What Causes The Recurring Boom And Bust Business Cycle?" (seekingalpha. com/ article/ 4519904-investors-can-profit-from-the-coming-recession)

    Since quantitative easing stopped earlier this year, the FRB is now engaged in quantitative tightening, or reducing the money supply by selling securities from its balance sheet. Among other problems, the FRB is not pursuing QT with the same vigor it pursued QE.

    "We’re in a world where there are going to be plenty of reasons for governments to spend,” says Dario Perkins, an economist at TS Lombard in London. “They have Covid to deal with, the energy crisis to deal with, if there’s a recession they’ll need to stimulate to deal with that. And the wartime economy, and climate change.” “But obviously then you have this sort of tug-of-war,” he says. “The more governments ease, the more worried central banks will be about inflation, so the more they’ll be tightening.” And hiking rates “has an immediate effect on government finances.”

    from "Tug of War That Markets Fear Is Central Banks Versus Governments" (Yahoo!News, October 16, 2022)

  8. DisgustedwithElitismOctober 17, 2022 at 6:25 AM

    A major, and rarely discussed, cause of the steadily growing "wealth gap" is the unrelenting decline in the velocity of money ("Velocity Of Money – Charts Updated Through April 28, 2022" at www. economicgreenfield. com/ 2022/04/28/ velocity-of-money-charts-updated-through-april-28-2022/; "Velocity of Money" at www. thebalance. com/ velocity-of-money-3306130, "Velocity of Money Chart").

    When money circulates it improves circumstances for everyone who (temporarily) holds it, enabling spending, investment, and saving. When the circulation of money slows, more are left out and suffer

    The steadily declining rate in the velocity of money means a new dollar goes through the economy ever faster, eventually ending up in the wealth hoards of the very rich. With quantitative easing and extraordinarily low interest rates for far too long (over a decade), the FOMC and the Federal Reserve Bank claimed to be "providing liquidity" for markets that benefitted the wealthy (bond investments...) at the expense of the middle class and the poor. If there was a bona fide liquidity problem, it was because the very people the FOMC helped were hoarding the latest tranche of new (further devalued) money.

    If there ever was a "liquidity crisis" requiring FRB intervention, these charts of the precipitous decline in the velocity of M1 and M2 explain it quite well - over the past 14 years, a "new dollar" almost ceased to circulate. Therein lies the explanation... we have experienced considerable business consolidation with fewer and fewer suppliers even as we hugely increased the number of dollars. That is the classic explanation for inflation, too many dollars chasing too few goods and services. We are in a supply-caused and government-caused inflationary environment as all that has been done since the FC '08/'09 has reduced the number of suppliers, ballooned the money supply, and boosted some segments of economy (housing...) while completing neglecting others (semiconductors, energy, infrastructure...).

  9. Following the US" depression " of the 1930s came the concept of cheap money to reanimate economy. But later era financing bid adieu to gold backed currency to pave way for leveraged finance to explode into globalised markets. Slack regulation with little or no emphasis on collaterals,enabled institutions to issue huge debt. Economies today being multidimensional and complex, floods of liquidity in crises tend to create great wealth without commensurate job growth.
    The 2008 Wall St collapse was to test the mettle of bankers and economists. The US govt gave a free hand to the Federal Reserve which could also bail out private giants like the AIG to which it extended $ 184 bln,(1.5 % of GDP), as loan. In time the Fed would return billions in profit to the taxpayers .Economic premises can but help set direction but the crux is letting professionally manned majors operate with true autonomy. Ukraine is already posing a conundrum of universal inflation.
    llll R.Narayanan, Navi Mumbai. lll

  10. If I understand Johns solution. It's that all deposits are now made at the Fed where they can be redeemed in full at any time.

    Instead of banks lending via deposits which are run prone, all of the loans are now backed entirely by selling equity in the open markets.

    I know the MM theorem says this alternative sourcing has 0 impact on the banks valuations, but I am curious in practice if the amount of funds to lend is literally going to be the same.

    Furthermore, in a severe downturn, wouldn't new loans still freeze up as shareholders are unwilling to sell in a downturn?

  11. This would likely greatly reduce threat amount of credit and leverage in the economy. While this would increase solvency and stability, who is the constituency that would push for such a banking regime? Consumers like easy credit and politicians like easy credit (gets them re-elected). Perhaps such a system could only be implemented after a huge financial disaster that wipes out debt and assets and effectively necessitates restarting the entire credit system from scratch?

    Also, rather than equities, which tap a different investor base, a better idea is to require banks to issue a portion of their loan book as a publicly listed closed-end fund, where income and principal is distributed as it is received. Investors who want immediate liquidity could sell their shares (perhaps at large discounts) for cash. Others (who do not need liquidity) could hold the security until all of the loans have matured. These funds will provide transparency on bank loan books as well as an independent MTM valuation. Moreover, they require the bank to partially fund itself from medium-term credit investors rather than “ready money” depositors. Right now banks are structured like non-transparent CDOs- with insured deposits being the AAA slice, bank debt being largely senior debt and bank shares being the equity slice. More transparency would be beneficial - I’d rather own a slice of the actual loan portfolio than a blind bond issued by the bank (well, except for the implicit CB put).

  12. "The Fed's interference in politics and fiscal policy is the second significant consequence of these post-crisis initiatives.
    Mr. Bernanke has assisted in financing an unprecedented government borrowing spree while masking its long-term repercussions.
    Taxpayers won't fully understand the cost of such borrowing until interest rates increase.
    Additionally, Mr. Bernanke has damaged the independence of the Fed by turning it into a political appendage of the Treasury on matters of regulation, taxes, and spending.
    "This might represent the biggest danger going forward, particularly if the Fed has to hike interest rates."
    The Wall Street Journal editorial, published in 2014, discusses Ben Bernanke's legacy as he prepares to lead the FOMC as chairman of the Federal Reserve Board.
    When they were first published, the Editorial Board seemed to have the ideal vision necessary foresight.


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