Edmund Cannon Banking Crisis University of Verona Lecture

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.

6 Revision of basic money supply model of banking Assets Liabilities Loans € 90 Cash € 10 Total € 100 Deposits € 100 Total € 100

7 The run on Northern Rock http: //www. youtube. com/watch? v=Ey. Vk 8 EI 6 as. Q&feature=related

8 Facts on bank runs Bank runs common in 19 th century and early 20 th 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 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 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 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 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 1970 s Make huge real estate losses in 1980 s 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 (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 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 2 a-7, which limits the assets that can be held.

27 Money Market Mutual Funds: investment rules under SEC Act (1940) rule 2 a-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 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 Northern. Rock: la corsa agli sportelli che annunciò la crisi finanziaria globale”