Banking panics and financial crises
I have been doing research on banking for some time. Much of this research is on “runs on banking systems” which also are called “banking panics.” More recently I have started work on financial crises, partly because of the financial turmoil that started in the middle of 2007, which came to a head as a crisis in September and October 2008.
Runs on banks or similar institutions such as money market funds are a long-standing problem, going back at least to medieval times and probably back to ancient Greece and Rome. My research emphasizes runs on banking systems and responses to those panics, with much of the research based on nineteenth-century U.S. experience. That said, knowledge of those earlier events made it obvious that runs on money market funds were bound to happen.
Talks on the Financial Crisis of 2007 and 2008
I’ve given quite a few talks to non-economist groups about the Financial Crisis of 2007 and 2008. I also have made some media appearances related to the crisis.
I was interviewed at the University of Carlos III in November 2011 and I hope the YouTube video will be up soon. I did a taped interview at the University of Francisco Marroquin a while ago. The interviews are up on YouTube. The first interview on YouTube is about how it all began and the roles of the U.S. government sponsored enterprises and a relatively small amount of securities tied to subprime mortgages.
In the second part of the interview on YouTube, I talk about financial innovation and why it is important for economic growth and the well being of people around the world. I also have appeared on television in the U.S. and Ireland.
The most recent talk as of this writing is the inaugural Carlucci lecture at the American University of Rome. The slides focus on the sovereign debt crisis. I tend to use pictures and discuss the slides rather than outline the talk on the slides, so these perhaps are less informative than they might be otherwise. I tend to think the talks are more interesting though.
The prior talk is a presentation in Ukraine in May 2011 as part of a conference on the crisis. This talk on “The Financial Crisis in the U.S.” gives an overview of the financial crisis. Rather than a lot of text summarizing what I am saying, the presentation is mostly charts and pictures illustrating my points and can’t really be read.
A major point of my recent talks is the transformation of the Financial Crisis of 2007-2008 into the Sovereign Debt Crisis of 2009-201?. While the difficulties appear to be confined to Europe so far, I am afraid that the wave of concern will engulf the U.S. federal government. This concern is not helped by the extraordinary U.S. government spending and deficits since 2009.
Money market funds were the trigger for the climax of the financial crisis in 2008. Margarita Samartín and I discuss the issues concerning money market funds in a section toward the end of our paper “Why Do Bank Promise To Pay Par On Demand?”. You might find that section interesting even if you’re not a professional economist and the theoretical or historical parts of the paper doesn’t interest you.
Earlier talks on the financial turmoil included material of interest to particular groups, so I have left the slides from one of them here.
In June 2008, I gave a speech to the national meeting of the Government Finance Officers Association. This is titled “The Financial Turmoil in 2007 and 2008” because it preceded the real financial crisis in September 2008 and includes an analysis of one particular development, the run on the Florida Government Investment Pool.
The Florida Government Investment Pool operated much like a U.S. money market fund. The run on this fund was essentially the same as an old-fashioned bank run. These developments in Florida are of interest to government finance officers around the U.S., because many states have similar arrangements. The run was of interest for other reasons, including the similarity of the investment pool’s operations to a money market fund.
I see no response to either the runs on the money market funds or the government investment pool that takes the possibility of old fashioned runs seriously. That is too bad. The SEC’s proposed reforms are doomed to be ineffective, as history and economic theory show all too clearly.
The Financial Crisis of 2007 and 2008
The trigger for the financial crisis was housing, and difficulties spread due to securities known as Collateralized Debt Obligations (CDOs). My paper with Paula Tkac on the crisis itself, “The financial crisis of 2008 in fixed income markets” highlights the role of these securities due to the difficulties valuing them. This paper was published in the Journal of International Money and Finance.
Paula and I wrote a subsequent paper on CDOs, “The financial crisis of 2008 and subprime securities”. This paper was published in “Financial contagion: The viral threat to the wealth of nations”. The versions available here are the working-paper versions because the published papers are copyrighted.
A related paper examines the link, or lack thereof, between the financial crisis and financial innovation. Many think the financial crisis was due to financial innovation. I doubt that. Some financial innovations made the crisis worse, but the underlying causes were there without financial innovaiton. The reasons for my doubt are outlined in “Financial Innovation and the Financial Crisis of 2007-2008”. This paper is being translated into Spanish for publication in a Spanish economics journal and is not a particularly technical paper.
In a more technical paper, “Systematic and liquidity risk in subprime-mortgage backed securities”, Mardi Dungey, Tom Flavin and I examine how the pricing of CDOs evolved with the financial crisis. We find that uncertainty associated with the financial crisis was associated with decreases in the values of these securities and that decrease continues to this day to affect the value of CDOs and real estate.
Banking History
There is a lot of history on bank runs and runs on banking systems. My paper “Wildcat Banking, Banking Panics and Free Banking in the United States” Federal Reserve Bank of Atlanta Economic Review 81 (December 1996), 1-20 summarizes a lot of what is known about bank runs in the free banking period in the United States.
The free banking period is informative partly because it is supposed to be an ear of wildcat banking when banks were organzied where the wildcats roamed. This paper dispells that notion but shows the little bit of truth in it.
Private — non–governmental — remedies developed for bank runs. R. Alton Gilbert and I focus on private remedies for bank runs in the National Banking period in “Bank Runs and Private Remedies” Federal Reserve Bank of St. Louis Review 71 (May/June 1989), 43-61.
I also have written papers primarily for professional economists.
Economics and Banking History
Why do banks promise to pay the face value, or par value, of their liabilities on demand if it is all but certain that they will not honor this promise at some unknown future date? To my mind, this most basic question about banking is a simple question. Banks promise to give you a dollar whenever you want in exchange for your giving them a dollar. Banks keep fractional reserves, which means that they inevitably cannot honor this promise at some point. If enough people want currency at one time, the bank runs out of currency. Sooner or later, enough people come to the bank at one time that the bank cannot honor the promise.
If banks didn’t make this promise, bank runs (called banking panics in the literature) would be impossible. Yet, banks make this promise. Why?
Margarita Samartín and I summarize the theories and provide some evidence from historical banking in “Why Do Bank Promise To Pay Par On Demand?”. The history is informative about the theories, suggesting that all the theories are informative about some of the history and no one theory is informative about all of banking history. None of the theories explains why money market funds operate to keep their net asset value at a dollar, which is the same thing as saying that money market funds operate in such a way that you can put in a dollar and get your dollar back later plus interest on demand. Our analysis shows that money market funds are subject to runs in the same way that banks are, as long as the funds guarantee to pay investors on demand no matter what happens to the value of the underlying assets.
Each of the theories examined in the paper explains some historical banking arrangements, but none explains current U.S. money market funds. Curious, isn’t it? This paper is published in the Journal of Financial Stability.
Unfortunately, this paper was prescient about money market funds. The analysis in “Why Do Bank Promise To Pay Par On Demand?” answers why money market funds made themselves vulnerable to a run. Short answer: their customers prefer to have their funds available on demand without worrying about the current market value of assets. This is so even though it is not possible to readily determine the value of the assets. It’s easy to state this preference; it is not so easy to make such a preference comprehensible in a coherent economic theory. No one has done it to date.
Today’s money market funds in the U.S. also provide an excellent example suggesting that electronic money is likely to be redeemable at par. Our analysis also indicates a key aspect of how electronic money is likely to work if it ever gets off the ground; it is necessary to be concerned about runs, either how to avoid them or how to deal with them.
Banks fail in runs. Why? It is easy to say after the fact that banks failed in runs because they were risky, but it may not have been obvious before hand. Rik Hafer and I examine banking panics in the free banking period to see whether banks that appear risky before the panic are more likely to fail. We find that banks failing in a panic did appear riskier by general financial criteria before the panic. This is an occasion when the conventional wisdom at the time is correct. This paper, “Bank Failures in Banking Panics: Risky Banks or Road Kill?”, was published in Bank and Financial Market Efficiency: Global Perspectives, volume 5, Research in Banking and Finance, edited by Iftekhar Hasan and William C. Hunter, pp. 47-70. Amsterdam: Elsevier Ltd., 2004.
Runs on the state banking systems occurred in the free banking period. Iftekar Hasan and I document the existence and some implications of bank runs in “Bank Runs in the Free Banking Period.” Journal of Money, Credit, and Banking 26 (May 1994), 271-88. You may be able to access this online. You can get a copy at many libraries or from me.
A suspension of payments is one way to deal with a bank run: in short, a bank or set of banks just quit paying out. This is what the fund that “broke the buck” in October 2008 did, but other funds did not do so. Such a joint action is called a “suspension of payments”. Iftekhar Hasan and I provide evidence on the effects of suspensions of payments in “Suspensions of Payments, Bank Failures and the Nonbank Publics’ Losses”. Our evidence indicates that, if banks are allowed to just quit paying out, fewer banks fail in the end and the final losses to noteholders are less. This paper was published in the Journal of Monetary Economics in 2007. The data on bank failures, losses and related variables are available by sending an e-mail to me.
The primary assets held by these banks were state and federal bonds. Changes in the prices of these bonds were important for the banks. Rik Hafer, Warren Weber and I published a paper that collected these data together. “Weekly U.S. and State Bond Prices.” Historical Methods 32 (Winter 1999), 37-42. You can get a copy of this paper at many libraries or from me. All of the data we used in the paper are available in an Excel spreadsheet. If you’d like the additional available data on Illinois and New York, there is another Excel spreasheet which includes those data.