1. 1 Understanding Financial Crises Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003

2. 2 Lecture 1 Banking Crises Franklin Allen University of Pennsylvania June 9, 2003 http://finance.wharton.upenn.edu/~allenf/

3. 3 Introduction What happened in Asia in 1997? What happened in Asia in 1997? Conventional wisdom about causes Conventional wisdom about causes Inadequate corporate governance Inadequate corporate governance Lack of transparency Lack of transparency Poor regulatory supervision Poor regulatory supervision Guarantees by governments and IMF Guarantees by governments and IMF

4. 4 But If these are the explanations why didn’t these crises occur before? If these are the explanations why didn’t these crises occur before? All of these factors were present while the economies were growing at fast rates for many years All of these factors were present while the economies were growing at fast rates for many years Crises occur in many situations where these factors are not present Crises occur in many situations where these factors are not present It is necessary to take a broad perspective It is necessary to take a broad perspective

5. 5 Banking and Currency Crises in the 19 th and Early 20 th Centuries Europe: Crises eliminated by central banks in the last half of the 19 th century Europe: Crises eliminated by central banks in the last half of the 19 th century Bank of England: Overend and Gurney crisis in 1866 and Bagehot (1873) Bank of England: Overend and Gurney crisis in 1866 and Bagehot (1873) US: Crises endemic in the last half of the 19 th and early 20 th centuries: US: Crises endemic in the last half of the 19 th and early 20 th centuries: Sep 1873, Jun 1884, Nov 1890, May 1893, Oct 1896, Oct 1907, Aug 1914 Sep 1873, Jun 1884, Nov 1890, May 1893, Oct 1896, Oct 1907, Aug 1914

6. 6 How do recent crises compare with previous crises? Bordo and Eichengreen (2000): Gold Standard Era1880-1913 Interwar Years1919-1939 Bretton Woods Period1945-1971 Recent Period1973-1998

7. 7 Bordo and Eichengreen’s (2000) Results Banking, currency and twin crises have occurred under many different regimes Banking, currency and twin crises have occurred under many different regimes Recessions with crises are more severe than those without them Recessions with crises are more severe than those without them Special features of 1880-1913, 1919-1938, 1945-1971 and 1973-1998 Special features of 1880-1913, 1919-1938, 1945-1971 and 1973-1998

8. 8 Issues Why do crises occur unless actively prevented by central banks and governments? Why do crises occur unless actively prevented by central banks and governments? What policies, if any, are required to prevent crises? What policies, if any, are required to prevent crises?

9. 9 Banking Crises: Two Theories 1.Crises as Financial Panics Kindleberger (1978), Diamond and Dybvig (1983) Kindleberger (1978), Diamond and Dybvig (1983) Multiple equilibria Multiple equilibria 2.Fundamental based crises Gorton (1988), Allen and Gale (1998) Gorton (1988), Allen and Gale (1998) Essential equilibria Essential equilibria

10. 10 Crises as Financial Panics Diamond and Dybvig (1983) model: DD Single good and two riskless assets Single good and two riskless assets Date0 12 Date0 12 Short asset y 1 1 1 Long asset x1 R>1 r<1 Liquidate

11. 11 Consumers Consumers Date 0 12 Date 0 12 2 ex ante 1 Early 1 Late 2 ex ante 1 Early 1 Late identical c 1 c 2 identical c 1 c 2 EU=u(c 1 )+u(c 2 ) EU=u(c 1 )+u(c 2 ) Endowment 1 Banks are competitive: Banks are competitive: Maximize EU of depositors Maximize EU of depositors

12. 12 Bank’s problem MaxEU = u(c 1 ) + u(c 2 ) MaxEU = u(c 1 ) + u(c 2 ) y,x,c 1,c 2 y,x,c 1,c 2 subject to y + x ≤ 2 c 1 ≤ y c 2 ≤ Rx + y – c 1 c 1 ≤ c 2

13. 13 Optimal solution c 1 = y c 2 = Rx u’(c 1 )/u’(c 2 ) = R c 1 < c 2 since u’’ < 0

14. 14 DD: Two “equilibria” at date 1 Good equilibrium implements optimum Good equilibrium implements optimum Early consumers withdraw at date 1 Early consumers withdraw at date 1 Late consumers stay until date 2 Late consumers stay until date 2 Bad equilibrium Bad equilibrium All withdraw at date 1 and c 1 =c 2 =(y+rx)/2 All withdraw at date 1 and c 1 =c 2 =(y+rx)/2 Equilibrium selection Equilibrium selection Sunspots Sunspots Lack of common knowledge – Morris and Shin (1998) Lack of common knowledge – Morris and Shin (1998)

15. 15 Policy implications Focus of policy is to rule out the bad equilibrium Focus of policy is to rule out the bad equilibrium DD suggest that deposit insurance does this at no cost DD suggest that deposit insurance does this at no cost

16. 16 Fundamental Based Crises Gorton (1988) found 19 th Century US crises are predictable Gorton (1988) found 19 th Century US crises are predictable Whenever the leading economic indicator represented by the liabilities of failed businesses reached a particular threshold a crisis occurred Whenever the leading economic indicator represented by the liabilities of failed businesses reached a particular threshold a crisis occurred

17. 17 Allen and Gale (1998) adapt DD model Short riskless asset and risky long asset Date 012 Safe asset y 1 1 1 Risky asset x 1 R>1 R learned R learned Now c 1 (R) and c 2 (R) but otherwise similar to before

18. 18 Optimal allocation Benchmark result: Banking crises allow the optimal allocation to be implemented even though deposit contracts are used Benchmark result: Banking crises allow the optimal allocation to be implemented even though deposit contracts are used

19. 19 Allen and Gale (2003) show that this result holds in a much more general model Allen and Gale (2003) show that this result holds in a much more general model With real shocks, optimal risk sharing requires contingencies and, given the debt-like properties of demand deposits, crises are the only way to achieve these contingencies With real shocks, optimal risk sharing requires contingencies and, given the debt-like properties of demand deposits, crises are the only way to achieve these contingencies

20. 20 Costly crises If banks have superior reinvestment possibilities from date 1 to date 2 of ρ > 1 while individuals can only use the storage technology the optimal allocation can be implemented if If banks have superior reinvestment possibilities from date 1 to date 2 of ρ > 1 while individuals can only use the storage technology the optimal allocation can be implemented if Contracts are nominal Contracts are nominal The central bank provides money to banks The central bank provides money to banks Resources stay inside the banking system Resources stay inside the banking system

21. 21 Optimal allocation Risk sharing occurs through variations in the price level Risk sharing occurs through variations in the price level

22. 22 Conclusions Banking crises can be Banking crises can be Financial panics Financial panicsOR Fundamental based Fundamental based Financial panics can be eliminated with deposit insurance Financial panics can be eliminated with deposit insurance Fundamental based crises eliminated by a central bank acting as lender of last resort Fundamental based crises eliminated by a central bank acting as lender of last resort