Download - 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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Insolvencyvs Illiquidity
(withoutLOLR)
1g
ts
runn
in
nofagen
Fractio
Assumecashholdings0
Return0
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Insolvencyvs Illiquidity
(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
ere s e qu y nso vency
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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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Insolvencyvs Illiquidity
(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
ere s e qu y nso vency
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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