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Financial Fragility

Q: 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. '

Q: 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.

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?

Banks are financed by demand deposits, which are very liquid. The assets of a bank are long term maturity loans which are vey illiquid. In normal times diversification allows banks to match inflows(loan proceeds) with cash outflows (cash withdrawals). However, when a bank faces unexpected high withdrawals (e.g. bank run) it may be forced to liquidate investments at a loss inciting further runs

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.

Is it unfair that health banks fail due to contagion?

A mananger might feel it is unfair that people run on their bank because of bad info on another, but if the bank is not prepared for such a market shock, how healthy is the bank than actually?

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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Financial Markets and institutions

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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?

What is the relation between liquidity and Bank Fragility?

What do we mean by the contagion effect in bank runs?

Is it unfair that health banks fail due to contagion?

What are remedies against bank runs?

What is "gambling for reseraction" and what might be a solution?

What are the key aspects of deposit insurance?

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