History “may not repeat itself”, but the
saga of US subprime loans and their after-effects on global financial markets
‘rhymes’ it.
The rocking of
the Northern Rock —the 7th biggest bank and the 5th biggest mortgage
lender of the UK that has been hit by the US subprime mayhem which, as Martin
Feldstein of Harvard University argued,
“Triggered a substantial widening of all credit spreads and freezing of
much of the credit markets” across the globe—by its depositors who queued up in
front of its branches to withdraw cash appeared to have at last eased with the
Finance Minister, Alistair Darling announcing that the Bank of England,
which incidentally stood stoically among
the major central banks in the current game of pumping liquidity into markets
besides cutting interest rates, would guarantee all existing deposits in
Northern Rock. Indications are that Darling’s pledge to do “everything we can
to ensure that the market returns to normal” after a panicked run on the
Northern Rock Bank has quelled the crisis.
Reports reveal
that in a single day, depositors have withdrawn about £1 bn, which amounts to
over 6% of its deposits. Its shares have fallen by more than 30%, and it
simultaneously pulled down the prices of other bank shares. Northern Bank is,
perhaps, the first bank of the UK in decades to be bailed out by the regulators
by providing an open-ended facility, whereupon it can access liquidity by
posting mortgages or mortgage-backed securities as collateral. All this has at last saved the bank from the
embarrassment of long queues of depositors lining up outside Northern Rock
branches across Britain to withdraw their deposits. This ‘run’ on Northern Rock
takes us back to 1907, when the US banks experienced a similar crisis.
Panic of 1907
Indeed, the
‘Panic of 1907’ was the most severe of the bank panics that overwhelmed the US
banks. It all started with the failure of one, F Augustus Henze’s scheme to
corner the stock of a not so important company—United Copper Company. But this
failure exposed Henze’s and his close “associate’s intricate network of
interlocking directorates” across banks, brokerage houses, and trust companies
of New York City. Under normal financial conditions, this would not have made
much difference, but the fall of 1907 was different: economy had been slowing,
stock market was witnessing downtrend, and interest rates were on the rise.
Over and above this, owing to rising interest rates in England, the usual
seasonal inflow of gold into New York was not happening. Nor could the money
supply be expanded in the absence of a Central Bank in those days of National
Banking era. Amidst this, Henze was forced to resign from the presidency of
Mercantile National Bank. This made the anxious bank depositors to begin a run
on the bank. Depositors began runs on even several banks controlled by Henze’s
associate. By October 21, the panic spread to the trust companies, with
National Bank of Commerce declining to clear the cheques for the Knickerbocker
Trust Company, the third largest trust in New York City. Incidentally, trust
banks, as a group, are different from commercial and investment banks. They
were administrators of trust funds—investors of
the money of estates, wills, and the like—but in the process created a
tenuous link to the markets by virtue of their making loans to market
speculators, of course against collaterals, and because of this
‘interconnectedness’ any fall in stock market would hurt them badly.
And, there being
no Central Bank—lender-of-the-last-resort—in those days, there were none to
loan these bodies money and prop them up. That is when JP Morgan entered the
scene by convening a meeting of trust company executives to work out a
mechanism to arrest further spread of the panic. Under his directions, experts
evaluated banks to identify those worthy of assistance. Morgan and his
associates convinced others to deposit personal cash in banks and help tide
over the crisis. Aid, thus, began coming from all sides: JD Rockefeller
deposited $10 mn with the Union Trust, while Morgan channeled around $3 mn to
Trust Company of America. By October 24, the panic spread to the New York Stock
Exchange: call money rates shot up to 100%. And even at that rate no money was
available. Again Morgan stepped into the stock market providing capital from
the pooled funds.
On October 26,
the clearinghouse entered the scene issuing clearinghouse loan certificates as
an artificial means to increase the supply of currency with banks against the collateral
of illiquid assets of banks. The banks that borrowed against their illiquid
assets from the clearinghouse in the form of certificates had to pay interest
on them. The certificates were then used to honor inter-bank obligations where
they replaced cash, which could then be used to pay depositors. Under this
arrangement of private clearinghouse system, member banks’ applications for
loan certificates were treated as confidential. In other words, the system had
not revealed the name of the weak member bank. The clearinghouse certificates
had functioned as a risk-sharing device by enabling members to jointly assume
the risk, which the individual member banks could not have achieved. During the
‘Panic of 1907’, clearinghouse loan certificates worth about $500 mn circulated
among the banks as a ‘principal means of payment’. Ultimately, it was the confidence restoring
act of JP Morgan, who worked together with the Secretary of the Treasury and a
few bank chiefs, that had seen the transfer of money to troubled banks and to
buy stocks, which ultimately calmed the markets.
Why panics?
Now, the
fundamental question is: Why banking panics? To understand the underlying
reasons for the panic, we must first define what a ‘banking panic’ is.
Calomiris and Gorton defined panic as an event in which bank debt holders
(depositors) at many or even all banks in the banking system suddenly demand
that their banks convert their debt claims into cash (at par) to such an extent
that banks cannot jointly honor these demands and suspend convertibility.
According to them, a panic is a system-wide phenomenon. And so long as the
banks are in a position to honor the withdrawals of large amounts, then such
withdrawals cannot be called panics. Similarly, a run on a single bank cannot
be said as banking panic.
The reasons for
such panics, therefore, cannot be one or two, but certainly a convergence of
many. And there is always a trigger—a shock that emanates from a sudden news,
just as the news of Heinze’s failure to
corner the stocks of United Copper in 1907 that made depositors to suddenly
doubt the liquidity or solvency of their banks and decide to hold cash rather
than deposits, leading to a run on one followed by many, ultimately
precipitating into a panic. Robert Bruner and Sean Carr, the authors of The Panic of 1907, have indeed cited as
many as seven conditions that jointly generated a perfect storm in the markets
leading to the panic of 1907: buoyant economic growth, the emergence of newer,
complex financial products that are difficult to value, inadequate safety
buffers, poor governmental leadership, over-optimism in markets, an economic
shock, and absence of collective action on the part of government and corporations to stave off an
impending crisis. And the recent mayhem in global financial markets that the US
subprime loans caused is indeed a testimony to the conclusions drawn by Robert Bruner and Sean Carr regarding bank
panics.
That is, in
fact, what even the general history of the bank panics reveal: “banking panics
are not a manifestation of an inherent problem with banks”, but an amalgamation
of unfavorable circumstances that finally makes banks end up in ‘runs’ leading
to panic in the market as indeed is happening today in the global financial
markets that are rocked by the US subprime loans. This is further evidenced by
the argument of Gorton and Huang that the likelihood of bank panics depends on
the structure of the banking system of a country. If a country’s banking system
consists of large size banks with wide branch network, there is a less chance
for banking panics, for they are better equipped to wither a storm by virtue of
their spread across a wide geography coupled with varied kinds of
businesses. On the other hand, if the
banking system is predominantly made up of small banks with undiversified
network, panics are more likely. Based on an extensive study, Bordo opined that
most severe cyclical contractions in all countries were associated with stock
market crises, but not with banking panics, except for the US. Another important revelation of research is
that bank panics “come at or near business cycle peaks”. Grossman, studying the
experience of Britain and Canada and a few other countries inferred that the
‘exceptional stability’ exhibited by banks in these countries is basically due
to: the structure of banking system in these countries, macroeconomic policy
and performance, and the behavior of the lender-of-the-last-resort.
Incidentally,
bank panics have a positive side: they serve an important economic function.
They induce better monitoring by depositors. This may also induce banks to form
coalitions and engage in self-monitoring. Indeed, history has shown that
private bank coalitions facilitate efficient ways of monitoring, for panics
impose ‘externalities’ on banks that are doing well, forcing them to subsidize
those who are not doing well, besides monitoring them well. This is perhaps one
reason why coalitions are found occurring only when panics are in motion.
Nonetheless, private bank coalitions have functioned well as
lenders-of-the-last-resort and thus provided a sort of deposit insurance during
the panic of 1907, which function has, of course, today been taken over by the
Central Banks. Indeed, it is the hero of the ‘Panic of 1907’, JP Morgan and his
role in bailing out the banks donning the role of the lender-of-the-last-resort
that paved the way for the establishment of the US Federal Reserve.
Calls for ex-ante monitoring
The first lesson
that comes to mind out of the foregoing arguments is that Central Banks have a
great role in averting such panics, and if they occur, in prudently mitigating
the adverse consequences as indeed the Fed and the Bank of England attempted in
the recent crises. The Central Banks should build such a supervisory
architecture that would enable them to deal with disaster myopia and exposure
to large shocks of unknown probability. Identification of weak banks may be
sufficient for managing crisis, but this mechanism is inadequate for the
prevention of crisis. To prevent crisis, Central Banks must essentially aim at
identifying banks that are getting heavily exposed to a major shock.
Identification
of emerging sources of systemic vulnerability entails a continuing inter-play
between assessing the exposure of a bank to a particular shock and assessing
the probability of that shock happening. Once vulnerability is measured using
relevant data, the Central Bank must pass on the information to the concerned
bank with instructions to assess if the exposure is prudent. If, on the other
hand, the bank is found taking such exposure deliberately, it must be asked to
undertake a specific stress test in order to ensure that it has the ability to
absorb such shocks.
The importance
of Central Bank’s monitoring role is well-echoed in what Bernanke said on
August 31, 2007 at the Federal Reserve Bank of Kansas City’s Economic
Symposium, Jackson Hole: “…when most loans are securitized and originators have
little financial or reputational capital at risk, the danger exists that the originators
of loans will be less diligent. In securitization markets, therefore,
monitoring the originators and ensuring that they have incentives to make good
loans is critical. I have argued elsewhere that, in some cases, the failure of
investors to provide adequate oversight of originators and to ensure that
originators’ incentives were properly aligned was a major cause of the problems
that we see today in the subprime mortgage market.”
As against this
requirement, in today’s financial markets, there is a lack of information and
transparency about risk. As Charles Goodhart, emeritus professor of banking and
finance, London School of Economics, observed, even Central Banks are
complaining about the on-going financial innovation that has made identification
of risk concentration very difficult. A need thus arises for the regulators to
overcome the hurdle by inventing effective means to acquire and monitor such
information. The other issue, which Charles Goodhart rightly brought out, is
the need to incorporate the information about contingency claims on banks to
monitoring authorities, for they have the nasty habit of transforming into very
real claims during a period of stress. Regulators have to, therefore, call for
such information and monitor it systematically.
There is a need
for pragmatic leadership such as that of JP Morgan during 1907 panic to handle
the crisis, to build confidence in the markets and thereby calm them, for no
government worth its salt can be oblivious to the fact that the developments in
financial markets will leave their adverse impact on many citizens who are in
fact outside the markets. As Bagehot argued in 1873 and JP Morgan proved in
1907 panic, Central Banks, in a crisis,
should lend liberally on collateral that ‘would be good’ under normal
circumstances, but should charge a high rate of interest. Leadership should
always bear in mind that Central Banking, as Goodhart argued, evolved as a
response to banks’ inability to cope with panics.
It may not
always be wise to take a stand that Central Bank “must not let the mistakes
made by some impose on those that made no mistake a high price,” for it would
unwittingly penalize those who have made no mistake—the depositors, for the
mistake of its executors, the banks. Bernanke was right when he said, “…it is
not the responsibility of the Fed—nor would it be appropriate—to protect
lenders and investors from the consequences of their financial decisions”. But
can a Central Banker afford to let the economy take a downturn, for it may
prove far more costlier than the costs imposed by the erring market players?
That’s what indeed Fed ultimately did: cut the Fed rate by 50 basis points.
In all this
argument against Central Banks bailing out the erring banks, what emerges as
the central point is the moral hazard: the risk of encouraging erring players
to continue with their risk-taking behavior under the knowledge that Central
Bank will bail them out. It is therefore the Central Banks’ duty to draw a clear demarcation of helping
those who are illiquid that too, at a high cost, just as Bank of England did in
the case of Northern Rock, and refrain
from supporting those who are insolvent.
It is, no doubt,
a big challenge to Central Banks to mitigate such crises in markets without
transgressing the moral hazard, for the demarcation between illiquidity and
insolvency is quite fuzzy. But they have no alternative except to handle the
predicament with effective ex-ante
monitoring.
(October, 2007)
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