The Bankwatch

Tracking the consumer evolution of financial services

banking 101 | All banks are vulnerable to runs

This is a fascinating and insightful paper by Willem Buiter and Anne Sibert on the failure of the Icelandic banking system, but with scary parallels to the UK system and others.  In particular though, and of interest to everyone possibly is section 2.1 copied below in full.  It defines the generic vulnerability that all banks’ have to “run a on the bank” even in good times.

Thus the argument goes, accept reality, nationalise the banks, and treat basic banking as a utility, just like water and electricity, until a better model can be developed that would have a better chance of surviving the coming sovereign debt crisis and transitioning into the new economic world that we are facing.

I fear the feeble attempts by heads of state of the western world to address banking and banks’ problems is failing, because banking is not understood.

The Icelandic banking crisis and what to do about it CEPR Policy Insight No. 26

2.1 All banks are vulnerable to runs

There is no such thing as a safe deposit-taking bank on its own, even if its assets are of good quality and it has enough liquid assets to cope with normal variations in the net flow of deposits and other short-term liabilities. The events since August 2007, and in particular the demise of Northern Rock in the United Kingdom and Bear Stearns in the United States, have made it clear that any highly leveraged institution with assets that are mostly long term and illiquid and liabilities that are mostly short term can be subject to a catastrophic liquidity shortage.

In the case of deposit-taking institutions, the canonical liquidity crisis is a bank run. Deposits can be withdrawn on demand and those who wish to withdraw are paid on a first-come, first-served basis. A bank run can occur if it is believed  rightly or wrongly that a bank is balance-sheet-insolvent (with assets worth less than liabilities).  But, as assets are illiquid, a bank run that cripples the bank is always possible, even if the bank is not believed to be balance-sheet insolvent: if each depositor believes that all other depositors are going to withdraw their assets then each depositor’s rational response is to withdraw his own. The outcome a bank  run validates the depositors’ beliefs: it is individually rational, but socially disastrous. The risk of cash-flow insolvency inability to meet one’s obligations including the obligation to redeem deposits on demand for cash is always present when assets are illiquid.

For highly leveraged institutions that fund themselves mainly in the wholesale capital markets, including the asset-backed securities and asset-backed commercial paper markets, an analogous event is  possible: in the belief that other creditors will be unwilling to roll over their loans to a borrower whose obligations are maturing or to purchase the new debt instruments the borrower is issuing, each  creditor finds it optimal to refuse to roll over his own loans or to purchase the new debt instruments the borrower is trying to issue, let alone to extend new credit. As with a classic bank run, this scenario can occur even when the assets of the bank are believed to be sound, if only they could be held to maturity.

Written by Colin Henderson

January 20, 2009 at 22:02

%d bloggers like this: