Tag: bank runs

35 years later: Diamond-Dybvig model of bank runs


Edward Prescott on was there a GFC?

V.V. Chari testifies on the information assumptions of modern macroeconomics and the risk of financial crises

Deposit insurance

Many of the key issues about what modern macroeconomics has to say on global financial crises and deposit insurance are discussed in a 2010 interview with Thomas Sargent

Sargent said that two polar models of bank crises and what government lender-of-last-resort and deposit insurance do to arrest or promote them were used to understand the GFC. They are polar models because:

  • in the Diamond-Dybvig and Bryant model of banking runs, deposit insurance and other bailouts are purely a good thing stopping panic-induced bank runs from ever starting; and
  • in the Kareken and Wallace model, deposit insurance by governments and the lender-of-last-resort function of a central bank are purely a bad thing because moral hazard encourages risk taking unless there is regulation or there is proper surveillance and accurate risk-based pricing of the deposit insurance.

In the Diamond-Dybvig and Bryant model, if there is government-supplied deposit insurance, people do not initiate bank runs because they trust their deposits to be safe. There is no cost to the government for offering the deposit insurance because there are no bank runs! A major free lunch.

Tom Sargent considers that the Bryant-Diamond-Dybvig model has been very influential, in general, and among policy makers in 2008, in particular.

Governments saw Bryant-Diamond-Dybvig bank runs everywhere. The logic of this model persuaded many governments that if they could arrest the actual or potential runs by convincing creditors that their loans were insured, that could be done at little or no eventual cost to taxpayers.

In 2008, the Australian and New Zealand governments announced emergency bank deposit insurance guarantees. In Bryant-Diamond-Dybvig style bank panics, these guarantees ward off the bank run and thus should cost nothing fiscally because the deposit insurance is not called upon. These guarantees and lender of last resort function were seen as key stabilising measures. These guarantees were called upon in NZ to the tune of $2 billion.

  • 1. The Diamond-Dybvig and Bryant model makes you sensitive to runs and optimistic about the ability of deposit insurance to cure them.
  • The Kareken and Wallace model’s prediction is that if a government sets up deposit insurance and doesn’t regulate bank portfolios to prevent them from taking too much risk, the government is setting the stage for a financial crisis.
  • The Kareken-Wallace model makes you very cautious about lender-of-last-resort facilities and very sensitive to the risk-taking activities of banks.

Kareken and Wallace called for much higher capital reserves for banks and more regulation to avoid future crises. This is not a new idea.

Sam Peltzman in the mid-1960s found that U.S. banks in the 1930s halved their capital ratios after the introduction of federal deposit insurance. FDR was initially opposed to deposit insurance because it would encourage greater risk taking by banks.

croaking cassandra

Late on Friday afternoon, Stuff posted an op-ed piece calling for the introduction of a (funded) deposit insurance scheme in New Zealand.  It was written by Geof Mortlock, a former colleague of mine at the Reserve Bank, who has spent most of his career on banking risk issues, including having been heavily involved in the handling of the failure, and resulting statutory management, of DFC.

As the IMF recently reported, all European countries (advanced or emerging) and all advanced economies have deposit insurance, with the exception of San Marino, Israel and New Zealand.   An increasing number of people have been calling for our politicians to rethink New Zealand’s stance in opposition to deposit insurance.   I wrote about the issue myself just a couple of months ago, in response to some new material from the Reserve Bank which continues to oppose deposit insurance.

Different people emphasise different arguments in making the case for New Zealand to…

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Review of #TheBigShort including of the movie

About the only time the Hollywood Left oozes with patriotism is when getting stuck into Wall Street. Hollywood must get its revenge for all those times investors did not back their film pitches, trimmed budgets and get the lion’s share of merchandising royalties and syndication profits. As Larry Ribstein explained:

American films have long presented a negative view of business…. it is not business that filmmakers dislike, but rather the control of firms by profit-maximizing capitalists… this dislike stems from filmmakers’ resentment of capitalists’ constraints on their artistic vision.

The Big Short is still a good film despite the left-wing populism, worth going to see. Its limitations in not discussing the monetary policy of The Fed or regulations that encouraged lending to high risk borrowers are justified poetic license and editing.

The film is already 120+ minutes long despite frequent resorts to breaking the fourth wall to explain technical terms, who was what and what they were doing, past and present. The Big Short is a film designed it make money at the box office, not a semester long documentary.

The Big Short is well acted, funny, insightful and still a good story despite the documentary element that was impossible to do without.

The Big Short highlights that its protagonists had skin in the game. They were investing in mortgages or shorting the same in the expectation of a crash. There were no windbags and armchair critics in The Big Short talking gloom and doom on the horizon without investing their own money to profit from their forecasts. That said, the protagonists betting on a sub-prime mortgages crash, bar two of them, were a little bit nutty.

I do not know any of the critics of the economics of the film’s explanation of the sub-prime crisis who suggested how they could fix these gaps in its economics without making the film much, much longer.

These critics fall into the exact same trap that the Big Short was not about. The Big Short was about investors to put their money where their mouth is. The critics of the film should put their script doctoring skills where their mouths are at least of The Big Short.

Source: What ‘The Big Short’ Gets Right, and Wrong, About the Housing Bubble – The New York Times.

Getting stuck into the role of the Fed and regulatory mandates on the banks regarding their level of sub-prime mortgages is for another film. Plenty of people warned of dark days ahead. An essay anyone can read with profit is Ross Levine’s “An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide?

Other films, correctly documentaries, place the blame for the sub-prime crisis and the Great Recession directly on the Fed:

The financial mess we’re still climbing out of can be laid directly at the feet of the Fed, whose misguided advocacy, under Greenspan, of a borrow-and-spend economy rather than a focus on savings and investment has created a situation where, as the title implies, money is disconnected from any underlying value.

There are plenty of points that could be added to the economics of The Big Short if it was a film of more or less unlimited length:

Krugman and friends like the film because it leaves out any discussion of the main culprit behind the financial crisis, which was not Wall Street “greed” but bad monetary and credit policies from the Federal Reserve and the federal government. The movie barely hints at any exogenous factors behind the boom or bust. (This FEE report by Peter Boettke and Steven Horwitz fills in the missing information.) So the pro-regulation crowd is cheering. Viewers are given no understanding of the real causal factors and hence fill in the missing data with a feeling that banks just love ripping people off. To be sure, if you approach this movie with some knowledge of economics and monetary policy, the rest of the narrative makes sense. Of course Wall Street got it wrong, given Washington’s policies on mortgage lending!

To add to the brew, Edward Prescott points out the Great Recession can be explained through productivity shocks. Specifically, a collapse in investment and in particular investment in intangibles such as intellectual property in 2007 in anticipation of more taxes and more regulation.

The Great Recession had many of the same features of the 1990s technology boom but in reverse. The boom in the 1990s and bust in 2007 were somewhat inexplicable because major sources of volatility were unmeasured, specifically, investment in intangible capital.

V.V. Chari also points out that the extent of the financial crisis was overstated. This is because the typical firm can finance its capital expenditures from retained earnings so it was hard to see how financial market disruptions could directly affect investment.

What Chari disputed was that bank lending to non-financial corporations and individuals has declined sharply, that interbank lending is essentially non-existent; and commercial paper issuance by non-financial corporations declined sharply, and rates have risen to unprecedented levels.

John Taylor argues that we should consider macroeconomic performance since the 1960: There was a move toward more discretionary policies in the 1960s and 1970s; A move to more rules-based policies in the 1980s and 1990s; and back again toward discretion in recent years.

These policy swings are correlated with economic performance—unemployment, inflation, economic and financial stability, the frequency and depths of recessions, the length and strength of recoveries. Less predictable, more interventionist, and more fine-tuning type macroeconomic policies have caused, deepened and prolonged the current recession. Robert Hetzel puts it this way:

The alternative explanation offered here for the intensification of the recession emphasizes propagation of the original real shocks through contractionary monetary policy. The intensification of the recession followed the pattern of recessions in the stop-go period of the late 1960s and 1970s, in which the Fed introduced cyclical inertia in the funds relative to changes in economic activity.

Finn Kydland considers fiscal policy to be at the heart of the slow recovery. Instead of restructuring and investing more prudently, Western countries faced with budget shortfalls will seek to increase taxes:

  • The U.S. economy isn’t recovering from the Great Recession of 2008-2009 with the anticipated strength.
  • A widespread conjecture is that this weakness can be traced to perceptions of an imminent switch to a regime of higher taxes.
  • The fiscal sentiment hypothesis can account for a significant fraction of the decline in investment and labor supply in the aftermath of the Great Recession, relative to their pre-recession trends.
  • The perceived higher taxes must fall almost exclusively on capital income. People must suspect that the tax structure that will be implemented to address large fiscal imbalances will be far from optimal.

Now imagine trying to incorporate all the above points into a film and keeping it at its current two-hour length?

The modern macroeconomics of the Global Financial Crisis


Did the GFC catch modern macroeconomists by surprise?

via Interview with Thomas Sargent | Federal Reserve Bank of Minneapolis

John Cochrane on a big hole in the Greek bailout (and media analysis of the bailout)

via The Grumpy Economist: Greece again.

Financial crises surprisingly common, but few countries close their banks

Real and Pseudo-Financial Crises, the Chinese share market crash and Anna Schwartz

If we could take time out from the breathless journalism about the Chinese stock market, which some people may have heard of before this week, it’s crash should be seen through the lens that Anna Schwartz developed in 1987 of a pseudo financial crisis and a financial crisis.

Her paper is written at the same time as the 1987 stock market crash. On financial crises, Anna Schwartz said:


As for those pseudo financial crises, she said:


Schwartz’s principal concern with regard to pseudo financial crisis was:

proposals to deal with pseudo-financial crises is the perpetuation of policies that promote inflation and waste of economic resources

As we are talking about the Chinese stock market, Anna Schwartz also wrote about the concepts of real systemic international risk and and pseudo international systemic risk.

Once again, and as with pseudo financial crises and real financial crises, what distinguishes real systemic international risk and pseudo international systemic risk is a threat to the payment system. The threat of bank runs, which can easily be eliminated through lender of last resort facilities:


As always it is about the security of the payments system – of avoiding bank runs, not private losses:


The lesson for the day is that when people start panicking about the economy or the stock market or international markets, don’t go to a macroeconomist for advice, go to a monetary historian. They have seen it all before.

The reason why New Zealand should rule out helping Greece!


Greece is a tiny part of the European economies so it doesn’t matter that much to the rest of the European Union what happens to Greece. The only people will notice the sovereign default of Greece once the breathless journalism has died down are Greeks themselves as they rebuild their banking and monetary system against a background of a government run by coffee shop Marxists.