Necessity of Governmental Intervention - Term Paper Example

What makes a run on bank? When is the government intervention necessary? A bank run which is also known as a run on the bank occurs when a lots of people take their deposits back as somehow they have lost the faith upon that bank and insecure about their money. A bank run progress is an automated momentum gaining process which is, said or believed comes true as the peoples are expecting it to come true: eventually as the deposition withdrawals increase the image of the bank falls provoking many withdrawals. Continuation of a bank run for long time can result in a bankruptcy as bank runs have a very ugly reputation. Insecurity during a bank run creates fear to same extent when the room is on fire. The panic drives us to the nearest visible exit blindly like a reflex without a single thought that the seen exit shown up like an oasis is really an exit or just a mirage. Sometimes it is better not to take risks with your money. The panic or “the shout” of a bank run is as fast and as growing like a fire. This panic takes an epidemic look as the depositors start to feel the same with other banks too as an incoming shock as this kind of economic disasters are very frequently on the headlines. It’s like when my friend’s bank is under a bank run the next bank could be mine. So a bank run is efficiently capable of contaminating its misfortune to cause several bankruptcies at least if the total economic breakdown is managed to block. (Shin, 2009) What causes bank run? Banks have an origin of centuries. Once they were just little shops that were used to collect fund from people and use them as to lend to the borrowers. This model, however, does not look much tough. Particularly in case of depositors, they can freely withdraw their money with a small penalty where a bank cannot ever ask for the money to be returned whenever they need it. Thus, an error arises in this model. In order to nullify this error a bank generally keeps a cash reserve which the bank uses to lend money to the borrowers taking only a little part from the deposits. However, if the bank is completely healthy it can survive a bankruptcy in the long run, but the sufferings of a bank run cannot be avoided when many people take their money back much than the cash reserved. So if a rough situation arises like this all depositors may not get their money back. The thing that makes the situation much worse is the first come first serve policy of the withdrawal. As long the bank have their cash reserve depositors can take their money back, but beyond the cash reserve level the bank is unable to return the money back. Hence, the insecure and desperate depositors rush to the bank to take their money bank thinking this to be a bank run. On forcing the borrowers to return fast the bank undergoes a loss as fire sales occur and the money taken back is very less may be less than the total deposits. In September 2007, a United Kingdom bank called Northern Rock experienced a severe bank run when depositors rushed to the bank to withdraw their money. UK experienced bank run even before. In case of US also bank run was not uncommon prior to 1930s. However, bank runs become rare after that. Why do bank runs exits?  There are three main reasons. (Shin, 2009) (I) Individual Liquidity Shock: Money could be needed in any time as an individual could suffer a liquidity shock for various reasons such as damage repairs from any sort of disaster, loss of earning, emergency hospitalization which leaves no choice to the depositors to withdraw their money. When the individual liquidity shock is completely independent and there are multiple depositors ten we consider it as the aggregate liquidity shock is non- stochastic, so in that case for a particular period of time a fixed amount of deposits are allowed to be withdrawn. This way the policy of cash reserve can resolve the bank run problem. In reality completely independent liquidity shocks are quite unrealistic as aggregate liquidity shocks are found normally in the time of currency crisis or natural disasters. That is, the aggregate liquidity shock is stochastic as well. Thus, unless the cash reserve is the entire deposits, there is a possibility of the occurrence of a bank run. As an example, a hyper inflation economy can lead to bank runs. (Kaufman, 1988) (II) Bad Loans: All the investments are not successful. In that case the initial principal is unrecoverable. It happens when the borrowers are unable to return bank what they have taken which result a loss for the bank as in the end bank leaves with less money from the initial deposits. As the news gets to the ears of the depositors they run to withdraw their cash and bank run occurs. If the bad loans occur independently and with multiple and random borrowers, then the aggregate amount of bad loans is non-stochastic. Hence, to manage the bad loan situation the bank needs to increase the interest amount. It should be known that increasing the interest amount will not increase number of bad loans. However, the recession over the country and world has shown that aggregate bad loans are stochastic too. Hence, for any interest implemented, there always stays a positive possibility that the bad loans exceed the interest earned. In such cases the chances of bank run come up again. For example, in the currency crisis, lots of businesses go bankrupt and thus the bank is unable to retrieve the loan. This leads to bank runs. (Kaufman, 1988) (II) Banks Losses: This is needed to be understood clearly. It is to be noted that the fund is not bank's its depositors, as a company, internal fund. The banks own money dosen't include the fund. Just as any other company it needs an internal fund. From which the bank pays its salaries, office rents, taxes and maintenance costs. This internal fund can be made from its profits, shareholders investment and other borrowed funds. Bank can surely borrow from their depositors which makes the bank borrower itself. But its internal funds are always independent of its deposits. A bank may look very cash-rich; its deposits are like its goods inventory only, which is absolutely different from its internal funds. So just as any other company a bank also deals with profit and loss. In essence, a bank incurs loss if its income is not in excess of its cost. Furthermore, a bank is bankrupt when it is not able to maintain the chain of deposits and borrows. (Kaufman, 1988) Just as any other company a bankrupt bank has to cease all its operations as well. Thus, all the loans have to be recalled, and all deposits returned. With the paradigm of deposits as goods, this is independent of the bank's financial obligation. Thus, the danger comes from the inability of the borrowers from returning the loan. Particularly when the bank is the borrower of itself the dangers are even greater. Knowing the danger depositors rush to withdraw their cash and this way a bank run occurs. In a case like this though there is no bad loans or liquidity shocks but still the bank undergoes a bank run. (Kaufman, 1988) For example the Nick Lesson case which brought down the Barings Bank London England by a loss of 1.3 billion dollars, this leads to a bank run. (Kaufman, 1988) Government intervention during bank runs When a popular bank is under a run government and the central bank takes a role in possible restorations generally. Numerous policy responses are possible, which is largely seen in these days but, the responses also vary from episodes to episodes. However, two key elements are normally found. First, at some point deposits are frozen according to requirement, meaning that further withdrawals are strictly limited. In Argentina, deposits were frozen for a period of 90 days beginning 1st of December, 2001; this freeze was carried out in many ways until early 2003. In US banking history deposit freezes are very common, last occurred in March 1933. Second, a rescheduling of payments occurs. Some demand deposits might be converted to time deposits with penalty criteria for early withdrawals. Additionally banks in these days want to hear the cause and analyze the importance and reason for this early withdrawal. (Bryant, 1980; Diamond and Dybvig, 1983) Now a day's deposit interests provided by governments enables the bank contracts that can dominate the best that can be offered without insurance never doing worse. The deposit insurance should be placed in way that keeps the model closed with assurance that no aggregate resource constraints are violated. Payments will be cleared to all who withdraw, it is promised in deposit insurance. (Bryant, 1980; Diamond and Dybvig, 1983) If the real value is guaranteed like this, the amount that can be guaranteed holds back: the government must set a compulsion on real taxes as an honor to the guaranteed deposits. The money creation causes inflation on nominal assets, which is the tax in case of nominal assets. This kind of taxation takes place even if there occurs no inflation; in any case, the levels of prices become higher than it would have been otherwise, and hence, nominally denominated assets are appropriated. Because a private insurance company is held back by it reserves in the scale without any conditional guarantees that it can present, so we often think that the insurance providers should be a government operated company which gives us a feeling of security. The deposits guarantee could also be made by a private company with the authority of taxation or create money to pay deposit insurance claims, still we think those organizations to be the branches of government companies as well. However, one can find some small competitive edge of commercially insured deposits that are limited by private collateral. It is assumed that the government is capable of levying. (Bryant, 1980; Diamond and Dybvig, 1983) It is interesting that the problems of runs and the differing effects of suspension of convertibility and deposit insurance manifest themselves in a model which does not introduce currency or risky technology. The demonstration leads to a conclusion that lots of troubles in banking is not necessary to be related with those factors. (Bryant, 1980; Diamond and Dybvig, 1983) The contracts of deposit insurance which the bank alone can enforce are potentially beneficial from government interferences into banking markets. In the contrary to common tax and subsidy programs, the intervention offers some kind of institutional framework under which it becomes possible for banks to operate smoothly. (Bryant, 1980; Diamond and Dybvig, 1983) If the bank manager selects the risk of bank portfolios, to some extent unseen by the outsiders, then a moral hazard problem would show up. In this case there is a trade-off between optimal risk-sharing and proper incentives for portfolio choice, and introducing deposit insurance can influence the portfolio choice. Some kind of government deposit insurance could be surely desirable but it would be associated with some sort of bank regulations. Bank regulations like this are the functioning restrictions to the legal contract executed. Through its discount portal, the Federal Reserve can, as a lender of last resort, gives a service like deposit insurance. The bank resources would be bought by the fed with tax emolument prices greater than the resources’ liquidating value. If identically the taxes and the transfers are set to steadfast optimal deposit insurance, the effect would be unaltered. The deposit insurances and discount window services are known for their riskless technologies. (Bryant, 1980; Diamond and Dybvig, 1983; Sherman, 2007) When the technology has risks, the lender of last resort no longer stays as creditable as deposit insurance. If banks always need the lender of last resort for bailing at the time of liquidity problems, there would be bad incentives for banks to take on risk. For instance, if a bailout is foreseen, all banks have an inducement of taking over interest rate risk by mismatching maturities of the accounts, because banks will all be helped together. If the bank is not helped by the lender of last resort, a bank can undergo a run as a reaction to changes in depositor doubt about the bank’s creditworthiness. A bank run can also occur in response to expectations of the general willingness of the lender of last resort to rescue the failing banks, as an example the unfortunate experience of the year 1930 when the Federal Reserve wrongly applied its circumspection and did not allow enough discounting. Comparing with deposit insurance which is a legal agreement constructed keeping the penalties that the bank officials, owner has to pay in case of a failure. (Bryant, 1980; Diamond and Dybvig, 1983) Very interestingly a deposit insured bank can provide liquidity insurance to another firm, which functions as a prevention from liquidity crises for a firm with short term debt and limit the requirements of the firm to use bankruptcy to put a halt to such crises. This concludes that the most aggregate liquidity risk in the U.S. economy is being channeled through its insured financial intermediaries, to such an extent where lines of credit represent binding promise. References: 1. Kaufman, G. G. 1988. Bank Runs: Causes, Benefits, and Costs. Cato Journal, 7(3): 559-594. 2. Diamond, D. W. and Dybvig, P. 1983.Bank Runs, Deposit Insurance, and Liquidity. Dybvig, P. H. 2000. Federal Reserve Bank of Minneapolis Quarterly Review, 24(1): 14–23. 3. Shin, H.S. 2009. "Reflections on Northern Rock: the bank run that heralded the global financial crisis", Journal of Political Economic Perspectives, 23:101-119. 4. Bryant, J. 1980. A model of reserves, bank runs, and deposit insurance. Journal of Banking and Finance 4 (December): 335–44. 5. Sherman, R. 2007 Market Regulation, Pearson, London. Read More