Lecture10 LOLR TU Berlin

8/6/2019 Lecture10 LOLR TU Berlin

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Lectureweek10


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Ban saret ere ecauset ereismar et a ure

Bankingsystemisfragile

Lowreturns insolvenc

Suddendemandfordeposits illiquidity

Onewaytolookatthedistinctionbetween

Insolvencywhennotabletopaybackcreditors(orde ositors eveninthelon run


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Putinde ositof1unit

No

Bank

Run Bank

Run

Withdraw W>1Riskof

receivin

0

Wait

vengrea er

RiskofRreceiving0

ere s e qu y nso vency


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Currentcrisis: iqui itycrisisorinso vencycrisis

Insolvencyasbadinvestment

Illiquidityasbadluck

Idea1.Youmightwanttorescueilliquidbanks,

butnotinsolventones. Inefficiency

MoralHazard

ButDDmodelshowsthatilli uidit ma tri erinsolvency,andviceversa

insolvency


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Bringinreturnsmoreclearly

illiquidity?

e a on

o

exper men Whatifwesaveilliquidbanks


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Insolvencyvs Illiquidity

(withoutLOLR)

1g

ts

runn

in

nofagen

Fractio

Return0


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(withoutLOLR)

1g

ts

runn

in

nofagen

Fractio

Assumecashholdings0

Return0


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(withoutLOLR)t

h

g

e

sy

ts

runn

in

olen

dity

nofagen

sol

iqui

Fractio i Il

Return


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Putinde ositof1unit

NoBankRun BankRun

Withdraw W>1Riskof

receivin

0TradeOff

Wait

vengrea er

Risk

of

Rreceiving0



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FrancisBaring(1797):

[]as money wasnotto be obtained []inthe market,they (merchants

and manufacturers,A.N.)were driven once more to the Bank(BoE,A.N.)as adernier resort.

HenryThornton(1802):

[]if the Bankof England,infuture seasons of alarm,should be disposed

to extend its discounts inagreater degree than heretofore,then the

threatened calamit ma be averted throu h the enerosit of thatinstitution.


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:

AndwiththeBankofEngland[]theseadvances[]shouldbemadeso

as if ossible to obtain the ob ect for which the are made. The end is to

staythepanic;andtheadvancesshould,ifpossible,staythepanic.


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Banksholdonly fraction of deposits informof liquidassets Runby depositors can lead to exhaustion of reserves

Result:Failure of solventbutilliquidbank

Justlike Diamondand Dybvig (1983),Rochet and Vives(2004)Contagious spread of bank failure

Contagion channels:

(i)psychological channel (weakend confidence infinancial system);

.

Cf.Chen(1999),Allenand Gale(2000),Freixas etal(2000),Dasgupta(2001)


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To stay the panic:

Lend freely,sothat emergency credit is always available

To avoid inflationary effects of policy:

Lend freely at ahigh rateof interest

To avoid lending to the wrongpeople:

en ree y at a g rateo nterest aga nst goo secur t es

Committo LLRactions inadvance.


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Agentsaroundthresholdexpecttoget

emer enc assistence fromLOLR


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(withLOLR)t

h

g

e

sy

ts

runn

in

olen

idit

nofagen

sol

liqu

Fractio i I

Return


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Putinde ositof1unit

NoBankRun BankRun

Withdraw W>1Riskof

receivin

0TradeOff

Wait

s o

receiving

0R



18/28

mp y yannounc ngt eL LR,t ecentra an reducespanicbasedruns

ec venesso spo cy ngescruc a yon

Fromtheagentsperspective:Credibility

Abilitytodistinguishbetweenilliquidityandinsolvency Fromtheagentsperspective:uncertainty:willtheCBcometo

rescue?

ThinkLehmannbrothers.

Fromthecentralbankperspective:shouldIrescuethisbank?

Centralissue:Longrunreturnsnotobservableorhardtovalue


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Goodhart (1999): To allege that distinction

between insolvent and illiquid institutions isgenerally possible is amyth

Idea3

,

problem:bankmaynothavethiscollateralavailable,evenif

ThorntonBagehotframework ignores the timeit usually

takes to evaluate collateral,to audit distressed banks etc.


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Targeted LOLRvs OpenMarket

Operations Idea4: marketbasedliquidityprovision

,

repo market sufficient

Responsibility for uncollateralized lending shifted to banks

butrecall:market imperfections main justification for existence of banks

.


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Lecture1&2theremaybemanymicroeconomicreasonswhymarketbasedliquidityprovisionworksbady


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Whydidliquiditynotgowhereitwas

necessary nUS, qu ty prov s on to 19pr mary ea ers.

Assetshardtovalue,evenformarkets Typicallyreliedonratingagencies

Ratingsfragileduringthecrisis

Marketvalueofassetsdroppedlikeastone

Intimesofcrises banks refertoholdali uidit cushionagainstshocksyettocome

Ormaybebanksreallyhadbadassets


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Insolvencyisphilosophy,illiquidityis

fact

oesa s u ycap ure e eao en ero LastResort?

Paniccanbepsychologicalriskofcontagion

Aninsolventbankgoingdowncanmakeotherbanksinsolventriskofcontagion

Centralbankmightwanttorescueeveninsolvent

Moralhazardandtimeinconsistency rw yemergencyass s ence sa a ea,an a e

sametimeunavoidable


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Credible LLRreduces cost of risktaking

But:Amount of bad debts might rise,whereas number of financial crises

might be reduced

as penalty rate to reduce moral hazard


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Goodhart 1999 ,Goodhart and Huang 1999 :CBfaces tradeoffbetween

moral hazard (i.e.shifting the burden of failure to taxpayer)and contagion

(meltdown of financial system,shifting cost of failure to taxpayer)

Any supportive action =insurance and thus:moral hazard problem

Neednotimply that insurance should never be undertaken

Freixas (1999):LLRintervention conditional onamount of uninsured debt

issued by the bank constructive ambiguity


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Bankmakes

Bank

potentiallyPolicymakersLOLRrescues

a ec s onannounces

facilityfor

insolventbanksto


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Solow(1982):Emphasis onrescue of financial

s stem rather than individualbanksContagion:Failureofbankinducesexternality

a itiona

cost

to

t e

economy

as

a

wholethatexceedsthelossesmadebythe

ownersofthefailedbank

Bankmakes

Bank

potentiallyPolicymakers

announcebad

Cheaperto

rescuebank

thantoletitgoa ec s onbankswontbe

rescued

bust


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ProblemofDiscretion:

Emergenceofaclubofinsiders

Problemofformalrules:

Favourslargebanks,

increasescompetitiveadvantageofsizeofbank

TradeoffbetweenformalandinformalLLRdesign

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Lecture10 LOLR TU Berlin