Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

Learning Outcomes (Chapter 2)

2

FINANCIAL INTERMEDIATION

FINANCIAL CRISIS & BANK RUNS

Clearly recognise the problems created by

liquidity transformation
Thoroughly analyse well-established
principles of the theory of bank runs
Fully describe and critically analyse the
system of international regulation of bank
capital adequacy with minimum guidance
List and carefully analyse the arguments in
favour of, and against, banking regulation

2013 Lillibeth Ortiz

Contents

Question

A.
B.
C.
D.
E.
F.

2007-2009 Financial Crisis

Bank Runs
Deposit Contract
Possible Solutions
Summary
Past Year Exam Questions, Essential
Readings

A. Financial Crisis: Background

5

What went wrong?

A. Financial Crisis: Why? How?

6

Housing market boom

Deregulation

of housing markets

Americans

spending more than they

produce
Asian savings redeployed in Americas
shopping spree

Financing from

capital markets: mortgage

backed securities & CDOs

Economic
Global

boom, lower interest rates

capital flows

Easier access

to financing home
Sub-prime mortgagers

Over-spending

Over-leveraged
FIs

had borrowed heavily to support

mortgage portfolios
Declining value losses banks collapse
Source: Fortune, By Colin Barr, September 26, 2008

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Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

A. Financial Crisis: Beginning of the

Collapse

A. Financial Crisis
8

Home prices plummeted in 2006-07

Mortgage

delinquencies rose
Forelosure filings increased 93 percent from
July 2006 to July 2007
Securitized mortgages led to large financial
losses

The increase in default rates led to:

Large

losses and uncertainty

reluctance to lend to each other

Banks

Higher interbank

interest rates
ST borrowing

Difficulty rolling over

Liquidity

Subprime mortgages

crisis

Countrywide

Financial bailed out and

eventually taken over by Bank of America

Source: Saunders & Cornett, Financial Institutions Management, 2011

A. Financial Crisis: Significant failures

and events

Bear Stearns funds filed for bankruptcy

by J.P. Morgan Chase
Fed moved beyond lending only to
Depository Institutions

A. Financial Crisis

By mid-March 2009, DJIA fell 53.8 percent in

less than 1 years
Record home foreclosures

Unemployment in excess of 10 percent

Acquired

Government seizure of Fannie Mae and

Freddie Mac
Lehman Brothers failure
Crisis spread worldwide

Source: Saunders & Cornett, Financial Institutions Management, 2011

in 45 in default in late 2008

Source: Saunders & Cornett, Financial Institutions Management, 2011

Dow Jones Industrial Average from

Oct 2006-Oct 2009

A. Financial Crisis

11

AIG bailout
Citigroup needed government support
Chrysler and GM declared bankruptcy in
2009
Goldman Sachs and Morgan Stanley
Only

Source: Yahoo finance

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survivors of the major firms

Source: Saunders & Cornett, Financial Institutions Management, 2011

Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

A. Financial Crisis: Rescue Plan

B. Liquidity Insurance Recall

14

Federal Reserve and other central banks

infused $180 billion
$700 billion Troubled Asset Relief Program
(TARP)
$827 billion stimulus program
American

2009

The service of improving liquidity through

offering of secondary securities which have
superior liquidity attributes compared to
primary securities is called ________
_____________
Banks

issue deposits that are cashable on

demand while its assets are illiquid
Deposits insure against random shocks to
investors preferences for the timing of
consumption

Recovery and Reinvestment Act of

Source: Saunders & Cornett, Financial Institutions Management, 2011

Question

C. Bank Run

15

16

What happens when too many depositors

withdraw at the same time?

C. Example: Bank Run on Northern

Rock
17

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Depositors panic and withdraw

immediately, including even those who
would prefer to leave their deposits in if they
were not concerned about the bank failing.

Other Examples
18

Source: BBC News, 17 Sep 2007

A bank run is when a large number of

depositors decide to withdraw their funds
for reasons other than _____________________

Mortgage lending Northern Rock

lends a large amount for
mortgages, and finances this with
money from banks and savers
Savings Northern Rock receives a
relatively small amount of money
from savers
Money markets Have stopped
lending money to Northern Rock
due to the crisis in the US subprime mortgage market
Bank of England Steps into the
breach to give Northern Rock an
emergency loan

Bank run expert: Cyprus' plan was 'absurd By Stephen

Gandel, March 19, 2013
http://finance.fortune.cnn.com/2013/03/19/cyprus-bankrun/
The slow bank run that could still doom Europe, By Brad
Plumer on September 20, 2012, Washington Post
http://www.washingtonpost.com/blogs/ezraklein/wp/2012/09/20/the-slow-bank-run-that-could-stilldoom-europe/
Run on Vietnam's biggest bank highlights threat to economy,
By Ian MacKinnon, 27 Aug 2012, The Telegraph
http://www.telegraph.co.uk/finance/newsbysector/banks
andfinance/9501953/Run-on-Vietnams-biggest-bankhighlights-threat-to-economy.html

Financial Intermediation Financial

Crisis & Bank Runs

Question
19

2013-2014

Exercise:
think-pairshare

C. Bank Run
20

Why do bank runs happen?

Bank

runs can arise due to:

A bank run on an ______________ bank is not

necessarily a bad thing
Disciplines

the performance of managers &

owners
Acts as an incentive for banks to maintain
liquidity

If depositors do not distinguish between

good and bad banks, they withdraw all
funds

A bank attempting to meet demands will incur

large losses

C. Illustration: Bank Run

C. Bank Run
22

Impact
Consultancy
& Training Pte
Ltd

Assets

Liabilities

Hong Kong man arrested over bank

run rumors
23

A bank run can in itself lead to default by a

bank that is not (pre-run) insolvent.
Bank runs cause
because it can make healthy banks fail,
causing the recall of loans and the
termination of productive investment.
Bank panic: systemic or contagious bank
run.

Another Example
24

HONG KONG - Hong Kong police have

arrested a man for allegedly spreading
rumors on the Internet about a bank run
amid anxiety in the Chinese territory about
the U.S. financial crisis, police said Sunday.
Police officers noticed Friday that the 34year-old man left a message on an Internet
discussion forum saying a run would occur
on a local bank and urging people to
withdraw their deposits...

Latvian bank run sparked by Twitter rumors,

Dec 12, 2011, By Bobbie Johnson,
Gigaom.com
http://gigaom.com/2011/12/12/latvian-bank-

run-sparked-by-twitter-rumors/

Source: AP, 09/28/2008

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Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

C. Bank Run

True or False?

25

26

Bank runs make intermediation more costly:

Depositors

need to monitor banks more

closely.
need to maintain more reserves for
liquidity.

Banks

Bank contagion has serious economic

consequences

A run on a bank is not necessarily a bad

occurrence.
A contagious run, or bank panic, differs
from a run on a bank in that a contagious
run involves loss of faith in the entire banking
system as opposed to just one bank.

Supply

of credit
supply
Social welfare effects
Money

Question

D. Nature of the Deposit Contract

27

28

What other factor encourages bank runs?

Diamond & Dybvig (1983):

Deposits have a feature called

Exercise:
think-pairshare

Illustration
29

Would you run or stay?

A RUNS
A STAYS

B RUNS
0.5 , 0.5
0,1

SSC means that banks must serve customers

wishing to withdraw funds on a first-comefirst-serve basis.
Banks must deal with customers sequentially
before knowing how many of their
customers will ultimately wish to withdraw
funds.

D. Nature of the Deposit Contract

30

B STAYS
1,0
1.2 , 1.2

There is a greater pay-off when the

depositor arrives sooner, than later, to
redeem deposit since deposits are:
Debt

claims

Redeemable

on demand
to likely default on the last
redemption

Subject

How does the structure of deposit contracts

contribute to bank runs?

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This means that the depositors place in line

matters i.e., SSC rewards those who arrive first to
withdraw their funds and thus

Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

True or False?
31

Question
32

Demand deposits pose a liquidity risk for FIs

because they are repayable upon
demand.
Abnormally large and unexpected deposit
withdrawals can occur because of
concerns by depositors about a banks
solvency relative to other banks.

E. Possible Ways to Reduce Bank

Runs
33

How do we prevent bank runs?

E. Possible Solutions
34

Suspension of convertibility

Deposit insurance

the devices traditionally used to stop or

Central bank lending

prevent bank runs:

Capital adequacy

Securitization (addresses problems with SSC)

Suspension
Demand

E. Possible Solution: Suspension of

convertibility
35

Diamond & Dybvig (1983) model analyses

of convertibility

deposit insurance

E. Possible Solution: Deposit

Insurance
36

Banks can suspend convertibility of deposits

to cash

Not

allow more than a certain fraction of

deposits to be withdrawn
Must be done at the proper time

Suspension is unpopular

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A promise to pay the amount promised by

the bank no matter how many depositors
withdraw
Removes incentive to participate in bank
run because deposits are safe
Works similarly to a central bank serving as
lender of last resort

Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

E. Possible Solution: Deposit

Insurance
37

Singapore says to guarantee all

bank deposits
38

Best for government to provide deposit

insurance

Government

has taxation authority, can levy

charges on bank, can provide a guarantee
against large losses without holding reserves
to back up their promise. (Diamond, 2007)

The city-state joins other global and Asian

governments such as Australia and New Zealand
that have given a blanket guarantee on all bank
deposits amid a crisis of confidence in the global
financial markets.
Source: Reuters, 16 Oct 2008, Reporting by Saeed Azhar and Koh Gui Qing;
Editing by Kevin Lim)

MAS has set aside S$20b facility to

protect depositors in Singapore

Singapore Deposit Insurance

39

Singapore will guarantee all local and foreign

currency deposits in banks, finance companies and
investment banks operating in the city-state ....
The guarantee will be backed by S$150 billion
($101.4 billion) of government reserves and will
remain in place until Dec 31, 2010...

40

http://www.sdic.org.sg/

E. Possible Solution: Central bank

lending
41

25 July 2012, Channel News Asia

SINGAPORE: The Monetary Authority of Singapore
has set aside a liquidity facility of up to S$20 billion
to protect depositors in Singapore.
MAS said it has entered into an agreement on
February 9 this year with the Singapore Deposit
Insurance Corporation Limited (SDIC) to provide the
contingent liquidity facility.
The facility can be tapped on "in the event a
deposit insurance scheme fails and liquidity is
needed for compensation payments to insured
depositors".

HK bank run hits Singapore, spurs

US$500M infusion
42

Discount window lending

Lender

of last resort facility

Another source of financing for banks

instead of selling illiquid assets at a loss

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Hundreds of nervous customers swarmed

Bank of East Asia offices in Singapore and
Hong Kong Thursday, the second day of
Asia's first major bank run since the global
financial crisis erupted last year.
Hong Kong's de facto central bank,
meanwhile, responded by injecting US$500
million into the market as a way of shoring
up the territory's banking system.
Source: 25 Sept 2008, The Associated Press

Financial Intermediation Financial

Crisis & Bank Runs

2013-2014

True or False?
43

F. Recap
44

In the event of a bank run, depositor claims

on the bank are satisfied on a pro rata
basis.
Deposit insurance is the only deterrent to
bank runs, contagious runs, and bank
panics.

Diamonds summary (2007):

An important function of banks is to create
liquidity i.e., offer deposits that are more liquid
than the assets that they hold
Banks

issue demand deposits that allow depositors to

withdraw at any time.
Banks make loans that cannot be sold quickly at a
high price.

F. Recap
45

Thus, there is a mismatch of liquidity: a banks

liabilities are more liquid than its assets

G. Past Year Exam Questions

46

This liquidity mismatch has caused problems for

banks when too many depositors attempt to
withdraw at once (a bank run)
Deposits have a feature called Sequential Service
Constraint which encourages bank runs
Banks have followed policies to stop runs, and
governments have instituted deposit insurance to
prevent runs

G. Past Year Exam Questions

47

Explain the relevance of the Diamond and

Dybvig (1983) model to liquidity insurance
and bank runs.(2011-Zone A, 2010-Zone B,
and 2009-Zone B)
Critically analyse the general arguments for
and against banking regulation, and with
particular reference to the role of the
deposit contract. (2009, Zone A)

G. Essential Reading & Sources

48

To what extent is the possibility of a bank

run an inevitable consequence of the
liquidity and maturity transformation
activities of banks? (2008, Zone A)
Explain the nature of liquidity risk, and
discuss the insights from the theory of bank
runs. (2008, Zone B)

Lillibeth Ortiz

Matthews & Thompson (2008) - Chapter 12.

Saunders & Cornett (2008) - Chapter 1,
pp.10 15; Chapter 17, pp.507-10
Bhattacharya & Thakor pp.250; Sections 4
&5