Financial Fragility
7 important questions on Financial Fragility
Who are most likely to run on a bank? what mitigates bank runs? What are the long term consequences of a bank run?
- Uninsured depositors are most likely to run
- Bank runs are mitigated by:
- Deposit insurance helps, but is only partially effective (depends on the account size
- Bank-depositor relationships mitigate runs (help reduce banks fragility)
- Social networks matter (If other people in a depositors network run, so does he or she.
3. Long-term effects of a solvent bank run: depositors who run don't come back (path-dependency)
What is the relation between liquidity and Bank Fragility?
What do we mean by the contagion effect in bank runs?
- If one bank goes bankrupt, deposit holders may interpret this event as a signal for the existence of solvency problems in the entire financial sector and react by a massive withdrawal of funds.
- This bank run may douse all banks to go bankrupt, even though most of them are fundamentally healthy.
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Is it unfair that health banks fail due to contagion?
What are remedies against bank runs?
- Narrow banking. Force banks to invest only in assets with short maturity
- Problem: Little value creation, since valuable investment projects are long-term
- Suspension of convertibility. no further withdrawals after a threshold is reached, no self-fulfilling bank rungs
- Problem: impractical, how to set such a threshold?
- Lender of last resort. Central banks provide banks with liquidity --> no self-fulfilling bank runs
- Problem: Moral hazard, investors have litte incentive to monitor banks
- Deposit insurance. If the bank can't pay, somebody else will --> no self-fulfilling bank runs.
- Problem: Moral hazard. So banks may take excessive risk to receive bonuses. "
What is "gambling for reseraction" and what might be a solution?
“Gambling for resurrection” (banking): when a bank takes larger risks as its equity falls, such as rolling over loans to struggling borrowers in attempt to avoid default
Bank management may take excess risk in order to receive bonuses when projects succeed, and when they fail and it leads to bank failure they are covered by the deposit insurance (Moral hazard problem). Solution might be to double the liabilities for equity providers, which means they lose double the amount if a bank fails.
What are the key aspects of deposit insurance?
- Owner / administrator (explicit or implicit insurance and private or public administration
- Coverage (types of deposits covered, coverage limit)
- Funding (funded or unfunded, risk adjusted or risk-insensitive premiums (i.e. leverage & riskiness of asset portfolio matter or not)
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