Econ 208 Marek Kapicka Lecture 16 Financial Intermediation

Wednesday Last class! Review: If you want me to go over specific things, me or ask me on Wednesday

A Liquidity Problem 1. Autarkic Solution 2. Market Solution 3. Efficient Solution 4. Banking Solution

Equilibrium without runs

5. Banking Solution Equilibrium with runs

Suppose that everyone decides to withdraw in period 1 Since 1. Not everyone in can be paid in period 1 2. Those who wait until period 2 will get nothing The bank will become insolvent

5. Banking Solution Equilibrium with runs A payoff matrix: late consumer (rows) vs every other late consumer (columns): Note: the run/run payoff is the expected payoff There are two equilibria: No run/No run (good equilibrium) Run/Run (bad equilibrium) RunNo Run Run No Run

Equilibrium without runs Equilibrium with runs

4. Banking Solution How to eliminate the bad equilibrium? Ways to eliminate the bad equilibrium Suspension of Convertibility Deposit Insurance Each of them has its own costs…

4. Banking Solution Solution 1: Suspension of convertibility

Examples: United States, Great Depression: A series of banking panics (October 1930, March 1931, March 1933), increasingly more severe Bank Holiday, March 6-March Banks were allowed to open only if licensed by the government Argentina, 2001

4. Banking Solution Solution 1: Suspension of convertibility Costs: 1. If the number of early consumers is unknown then the bank does not know when to suspend convertibility 2. Suspension of convertibility is not time consistent The bank would like to promise ex ante to suspend convertibility, but when the time comes, it would reconsider

4. Banking Solution Solution 1: suspension of convertibility early? late? early? ??

4. Banking Solution Solution 2: Deposit Insurance

Problems with Deposit Insurance: Moral Hazard Bank may take too much risk If successful, profits If unsuccessful, insured May create “too big to fail” problem”

4. Banking Solution Solution 2: Deposit Insurance 1934: Federal deposit Insurance Corporation (FDIC) established deposits up to $ insured Raised from $ in 2008 No large bank runs on commercial banks since the Great Depression

How is this related to the financial crisis? Read Gary Gorton: ``Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007” (on the web)

2. Shadow Banking What is shadow banking? Instead of people depositing money in the bank, firms and financial institutions deposit in a different financial institution The market is called repo market The “deposit” is collateralized with some assets The collateral can be used elsewhere

2. Shadow Banking Example of repo Microsoft: $1 million in idle funds Makes a loan to Goldman Sachs for a week GS uses $1 million worth of Treasury bills as collateral After a week, Microsoft gets back $1 million plus interest, GS gets back Treasury bills

2. Shadow Banking Similarities with commercial banking No 1: Deposits can be withdrawn at any time ~ Repo agreement can be terminated any time

2. Shadow Banking Similarities with commercial banking No 2: Deposits can be used in transactions (checks) ~ Collateral can be reused in other transactions (rehypothecation)

2. Shadow Banking Development of the shadow banking Over the last about 25 years, the importance of the repo market has grown dramatically Increased importance of collateral The size is estimated to be about 10 trillion USD For comparison: US GDP: about 14 trillion USD

2. Shadow Banking Development of the shadow banking

Shadow Banking What is a haircut? A % difference between a loan and the value of a collateral If Meryll Lynch borrows 95 million USD and is required to put up 100 million USD in collateral, the haircut is 5% Comparison with commercial banking 0 haircut is like checks being perfect substitutes to cash Positive haircut is like checks being traded at a discount

Shadow Banking A panic (run on repo) In a commercial banking, Everyone wants cash and no one wants deposits Deposits and are traded at discount Currency famine: disruption of transactions On a repo market, Everyone wants cash, and no one wants collateral Collateral is traded at a discount (haircuts increase) Shortage of collateral: disruption of transactions

Shadow Banking A panic (run on repo) One important difference: On a repo market, a decrease in the value of collateral forces financial institution to sell assets. That decreases the value of the collateral Amplifies the response

Shadow Banking A run on repo

Shadow Banking A Run on repo happened in Why did the bank run happen? Triggered by a “shock” (decrease in housing prices?) There is nothing like suspension of convertibility deposit insurance in the shadow banking system!

The lesson to take from this 2007 was very much like 1907!