Objectives: Consider how liquidity risks can cause financial instability and FI insolvencies.

1. Liquidity Risk, Central Banks, and Deposit Insurance • Objectives: • Consider how liquidity risks can cause financial instability and FI insolvencies. • Analyze a Central Bank’s role as lender of last resort. • Understand how deposit insurance alleviates bank runs but creates a need for bank regulation.

2. Liquidity Risk • Liquidity risk can arise when a FI’s liabilities obligate it to make payments that require liquidation (sale) of its assets. • Liquidity risk occurs in many types of FIs. Let us begin by illustrating this phenomenon in context of a depository financial institution (bank). • Recall that the typical bank provides transactions services, such as checkable accounts. It also provides lending services to borrowers, many of which require credit screening and monitoring and are not well-known by investors. • Combining these two different services implies that banks will issue short-maturity (or demandable) deposits and use these funds to make loans that are non-marketable (difficult to sell because the borrower’s creditworthiness is not publicly known.)

3. Therefore, suppose a bank’s liabilities consist of shareholders’ equity and demandable deposits (deposits that can be withdrawn on demand). Its assets consist of loans and cash (currency and money market instruments). Its balance sheet is • When deposit withdrawals are at a “normal” level, banks can use cashflows from loan payments and reduce their cash “reserves” (money market investments and currency) to meet deposit outflows. Bank Balance Sheet Assets Liabilities $ 8 Net Worth (Equity Capital) $ 92 Deposits $ 95 Loans $ 5 Cash

4. In addition to the normal desire to withdraw deposits to meet immediate consumption needs, if deposits are uninsured, depositors may withdraw their deposits to prevent a loss from the bank’s failure. • If depositors believe their bank’s net worth has fallen, they may attempt to withdraw their funds en masse, resulting in a “bank run.” This large withdrawal can, by itself, cause a decline in a bank’s net worth because there are “firesale costs” in unplanned liquidations of non-marketable loans. • To illustrate this, suppose that a depositor panic (bank run) occurs and $60 of deposits are withdrawn. The bank uses its $5 of cash to pay depositors but must raise another $55 cash. Due to “firesale costs,” this requires that the bank liquidate loans that would normally be worth $65 if held to maturity.

5. Bank Balance Sheet After Run Assets Liabilities $ 30 Loans $ 0 Cash $ -2 Net Worth (Equity Capital) $ 32 Deposits • Thus the bank run has led to the bank’s failure (negative net worth). This run may be an individually rational response to the fear of a loss in deposit value, but since it destroys the bank’s net worth it has an aggregate negative effect. • Depositor runs that lead to bank failures can have related social costs: • Breakdown of intermediation: Failed banks cannot provide credit screening, monitoring, or transactions services. • Monetary impact: If depositor withdrawals increase the demand for currency, monetary policy is contractionary.

6. Non-bank liquidity risks: • Commercial paper (CP) “walk”: Corporations issue CP, which is short-term (e.g., 30-day) debt similar to a bank CD. Investors will not buy new issues of the firm’s CP if they perceive a decline in the firm’s credit-worthiness. As CP gradually matures (walks), the firm cannot roll-over its CP and may need to access a BULC. • Insurance companies: If policyholders believe a company’s net worth has fallen, they may “surrender” their policies or take out policy loans, forcing the company to liquidate assets. Example: 1991 failure of Executive Life Insurance Co. • Firms with derivative contracts: Firms that experience losses on their derivative positions may be required to increase collateral (margin) backing these positions. This could lead to a liquidity crisis if they cannot borrow new funds. Examples: LTCM, Enron.

7. Note that open-end mutual funds (e.g., mmmfs) are less susceptible to runs because • They hold marketable assets (required to calculate NAV). Liquidating such assets would not tend to lead to “firesale costs.” • Mutual fund shareholders do not have an incentive to “run” because liquidating one investor’s share should not decrease the value of another’s. Unlike debtholders, equityholders obtain no benefit to being “first in line” when withdrawing funds.

8. A Lender of Last Resort • In some cases, private FIs (banks) would lend to other FIs experiencing a liquidity crisis in an attempt to avoid “contagion”: a deposit run at one bank might spread to others. • Recent examples: Morgan Guarantee lent to Continental Illinois prior to its 1984 failure. The NY Fed helped arrange loans by a consortium of banks to LTCM in 1998. • In response to a widespread banking panic (e.g., 1907), banks might suspend convertibility: allow check clearing but not withdrawal of deposits for currency. • Government Central Banks have been a lender of last resort: their ability to make loans is near limitless because of their ability to increase the supply (print) new currency.

9. Central bank (Bank of England) policy for operating during a crisis was outlined by Walter Bagehot (1826-1877), editor of The Economist, in his book Lombard Street: Internal drain: lend freely. External drain: raise interest rates. • The 1914 charter of the Federal Reserve stated that its main function was to provide an “elastic currency” by lending via the 12 regional Federal Reserve Banks’ Discount Windows. • However, in A Monetary History of the United States, Milton Friedman and Anna Schwartz document that the Fed failed in its duty to act of a lender of last resort during the 1930s. The Fed did not do sufficient discount window lending (or open market operations) to prevent waves of bank failures in 1931 and 1933. • In 1933, President FDR declared a “bank holiday” closing all banks for two weeks. One-third of them never re-opened.

10. The Fed now has a better understanding of its need to provide liquidity during a crisis. It expanded reserves (currency) via open market operations and through Discount Window lending during the 1987 stock market crash. • The Fed is now permitted to lend through the Discount Window even to non-bank FIs experiencing liquidity problems. Loans are at the Discount Rate, which is set above the Federal Funds Rate.

11. Deposit Insurance and Bank Regulation • Due to the widespread bank runs and failures of the 1930s, the Federal Deposit Insurance Corporation was established as part of the Banking Act of 1933, initially providing coverage of $2,500 per depositor. (Currently, $100,000 per depositor.) • Federal deposit insurance removes the incentive for depositors to start a run if they perceive their bank has become risky. • However, “market discipline” by uninsured depositors is lost: risky banks with deposit insurance will not suffer a run and their depositors will not require banks to pay a default-risk premium on insured deposits. • Whenever a government insures the liabilities (e.g., deposits) of a FI, moral hazard incentives are created.

12. To see this, consider the following example: • Let the (risk-free) interest rate on insured deposits be 10%. The bank can choose between Type A or Type B loans: • Note that Type B loans have an expected return of 0. Bank Balance Sheet Assets Liabilities $ 100 Loans $ 10 Equity Capital $ 90 Insured Deposits

13. If we calculate the bank’s expected return on equity, E[ROE], for these two types of loans, we obtain: • E[ROEA] = (100x1.15) - (90x1.1) = $16 • E[ROEB] = ½(100x1.5 - 90x1.1) + ½(0) = $25.5 •  bankrupt: equity = 0 • which implies that the bank would choose the inferior but more risky Type B loans. The expected loss to the FDIC when the bank selects Type B loans is • E[FDICB] = ½(0) + ½(100x0.5 - 90x1.1) = - $24.5 • not bankrupt   bankrupt

14. Besides selecting excessively risky assets (loans), an insured bank has the incentive for excessive leverage. To see this, suppose the bank issues $100 more in deposits, maintaining the same initial $10 in equity capital. • Now the expected ROE and FDIC loss on Type B loans is • E[ROEB] = ½(200x1.5 - 190x1.1) + ½(0) = $45.5 • E[FDICB] = ½(0) + ½(200x0.5 - 190x1.1) = - $54.5 • which shows that leverage increases the bank’s E[ROE] and the FDIC’s expected loss. Levered Bank Balance Sheet Assets Liabilities $ 10 Equity Capital $ 90 Insured Deposits $ 200 Loans

15. Note that the FDIC’s deposit insurance guarantee is analogous to a put option on the bank’s assets with an exercise price equal to the promised payment on insured deposits. • To prevent moral hazard that would increase the government’s (FDIC’s) losses, bank regulation is a necessary substitute for market discipline. • Bank regulators and supervisors must monitor banks to guard against excessive risk. In addition, relatively risky banks should be required to pay higher premiums for deposit insurance or maintain higher capital ratios (lower leverage). • The 1988 Basel accord and the current Basel II proposals are international agreements to provide a framework for setting risk-based capital standards. Banks whose balance sheets display greater VaR are required to have greater capital ratios.