achilles28
Registered: Apr 2005
Posts: 3461 |
11-04-09 07:38 PM
Quote from Martinghoul:
To me it's very simple and comes down to the good ol' "bank run" phenomenon.
If a large financial organization fails, no matter what guarantees the state provides, there may arise a crisis of confidence. In such an event investors might, quite literally, withdraw all capital needed to fund economic activity. This means that the whole system simply implodes, as it enters what Keynesians define as a "liquidity trap".
In the modern world, "bank runs" need not necessarily look like queues of depositors seeking to withdraw funds. In the case of Icelandic banks, they were refused further funding by foreign banks. With HypoRe, European counterparties refused to roll their repos. With global trade, insurance co's refused to provide letters of credit. With commercial paper, money mkt funds refused to buy it.
So that's my definition of 'too big to fail'. An institution is "too big to fail", if its failure can beget a negative feedback loop of ever increasing "runs". It's an entirely different question whether, given the complexity of the modern financial system, it's possible to avoid these 'chaotic' phenomena at all.
Quote from Kassz007:
You assume that people would still have confidence in the financial system, although they no longer have confidence in that particular institution. I think the loss of confidence in the financial system would be so great that many if not most citizens would withdraw their money from banks for good (or at least a long period of time until confidence resumes). This would virtually stop all capital from flowing anywhere, all liquidity would be eliminated, and it's very conceivable that markets as we know them could cease to exist.
As for why this didn't happen after Bear, Lehman, small banks collapsed - is because the government stepped in after this happened. I suspect that if the government hadn't stepped in after these firms went down, we'd see even more collapse at which point the average citizen would wake up and my scenario would play out. Since the government stepped in and prevented collapse, the average citizen wasn't driven to the point that they needed to "wake up".
These are both goods posts that echo related themes of confidence, solvency, and bank runs.
Last night, I erased a big post in response to Martin, but will summarize it again now.
The current banking system no longer relies on the principle of depositor confidence.
What I mean by that, is under the situations you both described, where depositors - and even short-term commercial lenders - withdraw funds from a distressed bank or pull credit lines, that bank could still continue normal operations. Even making loans, originating mortgages, generating profits etc.
The reason being the Fed. The "Lender of Last Resort".
The key is that our money is now 100% fiat. The money supply is no longer tied to Gold. Back in the Great Depression, it was. Banks could only issue credit/debt in a tight ratio to the amount of gold/deposits it had on its books. When a bank run occurred, depositors demanded their gold (or dollars backed by gold), the banks capital requirement went into deficit, distressed lenders wouldn't extend credit, assets had to be sold (in a down market), and they went under. Belly up. The last guy in line, may or may not, received his money.
Why didn't the Fed loan money to banks suffering from runs (haha!) during the Great Depression?
Because the Feds ability to print money/extend loans was regulated by the same Gold Standard. And the Fed didn't have enough gold to create enough loans to bailout all the insolvent banks!
Not today. Today, our money is 100% fiat.
What this means is the FED can print as much as likes - as we have seen - and lend that money to the distressed bank, who then lends it back to the FED to satisfy it's capital requirement short-fall when depositors pull their cash.
This double-lending (Fed loans to banks, who loan back to the FED), is being done right now, albeit to raise capital from mortgage losses.
This is why one bank run would not lead to 5, then to 10 etc. Because the confidence is in the Lender of Last Resort, and not any one bank, itself.
How, exactly?
Even if most depositors withdrew funds and most banks refuse credit lines, the FED can print (and lend) as much as the Bank needs to meet its capital requirement (or even create a surplus!), to therefore, enable the bank to continue normal operations (making loans, opening accounts, generating profits). Even to carry it long enough until public confidence is restored, deposits returns, and the Bank can maintain its own capital requirement, as the FED withdraws...
After that, its all political.
The FED offered near unlimited credit to some banks, and not to others. Bear Sterns and Lehman were "allowed" to fail. Allowed really means they were denied adequate short-term loans from the FED to meet their cap requirement. So they were forced into liquidation. A ton of smaller/regional banks were similarly denied adequate FED credit. So they failed. Yet, JPM, Citi, BoA borrowed as much as they wanted.
This is what's meant by picking winners and losers.
The FED loaned out 6-8 Trillion dollars. More than enough to save every bank in the US. Yet, many banks have been denied that credit. This is why America's largest Banks are even bigger than before the crisis.
They were given access to all the credit they needed to survive. Many of their competitors were not, and went under.
What are the implications of this?
Politically and Economically? 
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