THEORY OF BANK RUNS

Banks typically offer highly liquid, low price-risk contracts to savers on their liability side of the BS Banks typically hold relatively illiquid, high price-risk assets This is achieved through diversification of their portfolio risks; the more diversification achieved by the bank, the lower the probability that it will default on its liability obligations and the less risky, and more liquid, the claims

THEORY OF BANK RUNS

Potential fragility for banks arises because of financing LT-assets (eg loans) through ST-deposits, due to their exposition to the possibility that a high number of depositors will decide to withdraw their funds for reasons other than their liquidity needs The liquidity transformation function of banks makes them vulnerable to runs (the possibility that many depositors simultaneously seek to redeem their claims out of concern that the bank will default if they wait) Bank runs would not be a problem if they were confined to bans that were already (pre-run) insolvent; the threat of a run would act as a discipline in giving banks an incentive to avoid insolvency or the appearance of insolvency

THEORY OF BANK RUNS

Diamond and Dybvig (1983) show that a bank run can in itself cause a bank to default that would not otherwise have defaulted; if enough other depositors are running, it becomes each depositors best strategy to run themselves, thus, a bank run becomes self-reinforcing, or a Nash equilibrium in game-theory terms A bank attempting to meet demands by more than a certain proportion of its depositors will incur losses so large that its default becomes inevitable In this model, any event that causes depositors to anticipate a run, also makes them anticipate insolvency; in fact, it causes a run and so the outcome validates the anticipation. Contagious runs lead to a panic

THEORY OF BANK RUNS

Alternative to Diamond and Dybvig: both types of agents withdraw funds in period 1, that is, there is a run on the bank. Two policy initiatives can prevent this outcome:
Suspension of convertibility, preventing the withdrawal of deposits Provision by regulatory authorities of a deposit insurance scheme, which removes the incentive for participation in a bank run because the deposits are safe. The regulator can finance the scheme by levying charges on the banks. Given that no bank runs occur, the charges will be minor after the initial levy to finance the required compensation fund.

Thus, the model supports a form of deposit insurance to remove the incentive to run

THEORY OF BANK RUNS

Normal conditions (and appropriate management planning): neither net deposit withdrawals, nor the exercise of loan commitments pose significant liquidity problems, because borrowed funds availability or excess cash reserves are adequate to meet anticipated needs (even in December and the summer vacation season, when net deposit withdrawals are high, banks anticipate these seasonal effects by holding larger than normal excess cash reserves or borrowing more than normal on the wholesale money markets

THEORY OF BANK RUNS

Major liquidity problems arise if deposit drains are abnormally large and unexpected. Abnormal deposit drains (shocks) may occur for a number of reasons, including:
Concerns about a banks solvency relative to those of other banks Failure of a related bank leading to heightened depositor concerns about the solvency of other banks (the contagion effect) Sudden changes in investor preferences regarding holding nonbank financial assets (eg T-bills or mutual funds shares relative to deposits)

In such cases, any sudden and unexpected surges in net deposit withdrawals risk triggering a bank run that could eventually force a bank into insolvency

THEORY OF BANK RUNS

Recent contribution: Skeie (2004) showed that, with demand deposits payable in money using modern electronic payment systems, panic runs do not occur if there is efficient lending among banks. Aggregate shocks also do not cause bank runs because nominal deposits allow consumption to adjust efficiently with prices. However, Skeie finds that if inter-bank lending breaks down, bank runs occur as the result of a coordination failure in which banks do not lend a bank in need, and can lead to price deflation and contagion to other banks being run

THEORY OF BANK RUNS

At the core of bank run liquidity risk is the fundamental and unique nature of the demand deposit contract. These are first-come, first-served contracts in the sense that a depositors place in line determines the amount he or she will be able to withdraw from a bank; a depositor either gets fully paid or gets nothing (assuming there is no deposit insurance and no discount window borrowing to fund a temporary liquidity need for funds) Demand deposit contracts pay in full only a proportion of depositors when a banks assets are valued at less than its deposits and because depositors realize this any line outside a bank encourages other depositors to join the line immediately, even if they do not need cash toady for normal consumption purposes

THEORY OF BANK RUNS

As a bank run develops, the demand for net deposit withdrawals grows. The bank may initially meet this by:
Decreasing its cash reserves Selling off liquid or readily marketable assets (T-bills and Tbonds) Seeking to borrow in the money markets

As a bank run increases in intensity, more depositors join the withdrawal line, and a liquidity crisis develops; thus, the bank finds it difficult, if not impossible, to borrow on the money markets at virtually any price; moreover, it has already sold all its liquid assets, cash and bonds as well as any salable loans

THEORY OF BANK RUNS

The bank is likely to have only left relatively illiquid loans on its asset side of the BS to meet depository claims for cash; these loans can be sold or liquidated only at very large discounts from face value A bank seeking to liquidate LT-assets at fire-sale prices to meet continuing deposit drains faces the strong possibility that the proceeds from such asset sales are insufficient to meet depositors cash claims; thus, the banks liquidity problem then turns into a solvency problem, forcing the bank to close its doors

THEORY OF BANK RUNS

Regulatory mechanisms were established to ease banks liquidity problems and to deter bank runs and panics, the two major liquidity risk insulation devises being the deposit insurance and the discount window Government regulators of banks have established guarantee programmes offering deposit holders varying degrees of insurance protection to deter bank runs; specifically, if a deposit holder believes a claim is totally secure, even if the bank is in trouble, the holder has no incentive to run. The deposit holders place in line no longer affects his or her ability to obtain the funds. Deposit insurance deters both runs as well as contagious runs and panics

THEORY OF BANK RUNS

Additionally, central banks (eg the FED), have traditionally provided a discount window facility to meet banks ST non-permanent liquidity needs, through offering 3 lending programmes:
Primary credit: available to generally sound banks on a very ST basis, typically overnight, at a rate above the Federal Open Market Committees (FOMC) target rate for federal funds Secondary credit: available to banks that are not eligible for primary credit. It is extended on a very ST basis, typically overnight, at a rate above the primary credit rate Seasonal credit: designed to assist small banks in managing significant seasonal swings in their loans and deposits. This is available to banks that can demonstrate a clear pattern of recurring intrayearly swings in funding needs. Eligible banks are usually located in agricultural or tourist areas