International banking lecture 3 key concepts

how do banks sequential services work?

First come first served until assets run out, depositors arrive in random order

What is the good equilibrium in terms of banks sequential services?

everyone believes only the genuinely early types will withdraw, type 1 will not wait and consumption is worth nothing to them at t=2, type 2 will not run

What is the bad equilibrium in terms of banks sequential services?

type 2 depositor believes all other type 2s will withdraw at t=1, there will be nothing left to withdraw at t=2

What are the two main points which cause bank runs? Explain

Illiquidity (face value of deposits at t=1 exceed liquidation value of assets), sequential service (the maturity transformation the bank exists to do)

What are two things a bank run destroys? Explain

liquidation losses (long-term projects interrupted), risk-sharing destroyed (instead of insurance contract depositors face a lottery over the queue with an expected payoff below 1)

What is Diamond and Dyvbigs answer to why anyone deposits?

if the perceived probability of a run is small enough, the expected gain from liquidity insurance still outweighs it, and depositing is rational

What are three options to prevent runs? Explain

Narrow banking (stop bank from being illiquid in the first place), suspension of convertibility (let bank close the doors once withdrawals pass a threshold), deposit insurance (guarantee the payment)

What is narrow banking?

bank holds enough liquid assets to repay all depositors at face value in any period (t = 1), match maturity of assets to maturity of liabilities

How does narrow banking prevent bank runs?

Stabilises the banking sector by abolishing maturity transformation, removes the reason the bank existed

What is suspension of convertibility?

bank announces in advance that once withdrawals at t=1 reach a certain amount, they stop paying

How does suspension of convertibility prevent bank runs?

the bad equilibrium is made impossible with waiting becoming a dominant strategy

What risk does suspension convertibility have?

risk-sharing as bank cannot condition threshold on something it cannot observe, type 1s end up with nothing

How does deposit insurance prevent bank runs?

Third party guarantees that depositors receive the promised payment whether or not the bank can pay it, depositors don’t care about queue position as they are guaranteed money

Why is deposit insurance better than suspension for bank runs?

deposit insurance doesn’t have the risk of risk-sharing or preventing runs once the share of early types is random as it can be publicly ran, guarentee removes incentive to run

Why does deposit insurance use the government and not a private insurer?

private insurer has to hold reserves to make its promise credible whereas government has the power to tax so its promise is credible without holding anything

What are three risks of deposit insurance? Explain

Moral hazard (if depositors are guaranteed return, there is no reason to care what the bank does with money so monitoring by creditors stops), bank has an incentive to take more risks as taxpayers hold the downside, even a costless scheme needs a tax if it is ever called upon

What is the most used method to prevent bank runs?

Deposit insurance

Does narrow banking: stop bank runs? Keep insurance? Main cost?

Yes, no, abolishes bank function

Does suspension: stop bank runs? Keep insurance? Main cost?

Yes, only if amount of money available is known, rations genuine early types

Does deposit insurance: stop bank runs? Keep insurance? Main cost?

Yes, yes, moral hazard on the asset side

What are Diamond and Dyvbigs own ideas to why a bad equalibrium (bank failure) can happen? (4)

bad earnings report, run observed at another bank, gloomy government forecast, sunspots

Sunspot definition

a publicly observed random variable that does not enter preferences, endowments or technology (e.g. a false claim about a project closing when it didn’t)

What is the alternative to bank runs, information based runs?

let depositors receive signals about how the bank’s assets are actually performing and decide whether to withdraw on that basis, so runs have a fundamental cause and close banks deserved closing

What are the two arguments about bank runs being beneficial?

runs discipline banks who would otherwise misbehave, runs close banks that ought to be closed

How does a bank run discipline bankers? (Calomiris & Kahn)

run liquidates project first before banker can take deposited funds and disappear, possibility of a run is what makes depositors willing to fund socially worthwhile projects

How does a bank run benefit by shutting banks?

if a bank has a known risky return so closing bank is beneficial as bank shouldn’t be operating under a guaranteed risky return

Why do managers of banks keep them open when they should close?

If things go well then shareholders keep everything whereas if it turns bad shareholders lose first and depositors absorb remaining loss so not really any loss for shareholders but really bad for depositors

How does a bank run close a bank?

depositors see a bank going badly they run, forcing liquidation and shutting a failing bank