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Econ 208

Econ 208. Marek Kapicka Lecture 16 Financial Intermediation. Wednesday. Last class! Review: If you want me to go over specific things, email me or ask me on W ednesday. A Liquidity Problem. Autarkic Solution Market Solution Efficient Solution Banking Solution.

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Econ 208

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  1. Econ 208 MarekKapicka Lecture 16 Financial Intermediation

  2. Wednesday • Last class! • Review: If you want me to go over specific things, email me or ask me on Wednesday

  3. A Liquidity Problem • Autarkic Solution • Market Solution • Efficient Solution • Banking Solution

  4. 5. Banking SolutionEquilibrium without runs: Equilibrium without runs

  5. 5. Banking SolutionEquilibrium with runs • Assume that the bank operates under a sequential service constraint: • Everyone who comes to the bank in period 1 is paid , until bank resources are depleted • The liquidated value of all the bank’s assets is

  6. 5. Banking SolutionEquilibrium with runs • Suppose that everyone decides to withdraw in period 1 • Since • Not everyone in can be paid in period 1 • Those who wait until period 2 will get nothing • The bank will become insolvent

  7. 5. Banking SolutionEquilibrium with runs • A payoff matrix: late consumer (rows) vs every other late consumer (columns): Note: the run/run payoff is the expected payoff • There are two equilibria: • No run/No run (good equilibrium) • Run/Run (bad equilibrium)

  8. 5. Banking SolutionEquilibrium without runs: Equilibrium without runs Equilibrium with runs

  9. 4. Banking SolutionHow to eliminate the bad equilibrium? • Ways to eliminate the bad equilibrium • Suspension of Convertibility • Deposit Insurance • Each of them has its own costs…

  10. 4. Banking SolutionSolution 1: Suspension of convertibility • Suppose that the bank can refuse to pay deposits in period 1if the number of withdrawals equals the number of early consumers • Then waiting guarantees in period 2 • Thus, no late consumers decide to run

  11. 4. Banking SolutionSolution 1: Suspension of convertibility • Examples: • United States, Great Depression: • A series of banking panics (October 1930, March 1931, March 1933), increasingly more severe • Bank Holiday, March 6-March 13 1933 • Banks were allowed to open only if licensed by the government • Argentina, 2001

  12. 4. Banking SolutionSolution 1: Suspension of convertibility • Costs: • If the number of early consumers is unknown then the bank does not know when to suspend convertibility • Suspension of convertibility is not time consistent • The bank would like to promise ex ante to suspend convertibility, but when the time comes, it would reconsider

  13. 4. Banking SolutionSolution 1: suspension of convertibility late? early? ?? early?

  14. 4. Banking Solution Solution 2: Deposit Insurance • Suppose the government guarantees that each depositor will receive • Tax all consumers in period 1 to finance this in case bank run happens • Then no late consumer will withdraw in period 1 even if he believes that everyone else withdraws in period 1 • Bank run will not occur

  15. 4. Banking Solution Solution 2: Deposit Insurance • Problems with Deposit Insurance: • Moral Hazard • Bank may take too much risk • If successful, profits • If unsuccessful, insured • May create “too big to fail” problem”

  16. 4. Banking Solution Solution 2: Deposit Insurance • 1934: Federal deposit Insurance Corporation (FDIC) established • deposits up to $250000 insured • Raised from $100000 in 2008 • No large bank runs on commercial banks since the Great Depression

  17. How is this related to the 2007-2009 financial crisis? • Read Gary Gorton: ``Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007” (on the web)

  18. 2. Shadow BankingWhat is shadow banking? • Instead of people depositing money in the bank, firms and financial institutions deposit in a different financial institution • The market is called repo market • The “deposit” is collateralized with some assets • The collateral can be used elsewhere

  19. 2. Shadow BankingExample of repo • Microsoft: $1 million in idle funds • Makes a loan to Goldman Sachs for a week • GS uses $1 million worth of Treasury bills as collateral • After a week, Microsoft gets back $1 million plus interest, GS gets back Treasury bills

  20. 2. Shadow BankingSimilarities with commercial banking • No 1: • Deposits can be withdrawn at any time ~ Repo agreement can be terminated any time

  21. 2. Shadow BankingSimilarities with commercial banking • No 2: • Deposits can be used in transactions (checks) ~ Collateral can be reused in other transactions (rehypothecation)

  22. 2. Shadow BankingDevelopment of the shadow banking • Over the last about 25 years, the importance of the repo market has grown dramatically • Increased importance of collateral • The size is estimated to be about 10 trillion USD • For comparison: US GDP: about 14 trillion USD

  23. 2. Shadow BankingDevelopment of the shadow banking

  24. Shadow BankingWhat is a haircut? • A % difference between a loan and the value of a collateral • If MeryllLynch borrows 95 million USD and is required to put up 100 million USD in collateral, the haircut is 5% • Comparison with commercial banking • 0 haircut is like checks being perfect substitutes to cash • Positive haircut is like checks being traded at a discount

  25. Shadow BankingA panic (run on repo) • In a commercial banking, • Everyone wants cash and no one wants deposits • Deposits and are traded at discount • Currency famine: disruption of transactions • On a repo market, • Everyone wants cash, and no one wants collateral • Collateral is traded at a discount (haircuts increase) • Shortage of collateral: disruption of transactions

  26. Shadow BankingA panic (run on repo) • One important difference: • On a repo market, a decrease in the value of collateral forces financial institution to sell assets. That decreases the value of the collateral • Amplifies the response

  27. Shadow BankingA run on repo

  28. Shadow Banking2007-2008 • A Run on repo happened in 2007-2008 • Why did the bank run happen? • Triggered by a “shock” (decrease in housing prices?) • There is nothing like • suspension of convertibility • deposit insurance in the shadow banking system!

  29. The lesson to take from this • 2007 was very much like 1907!

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