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Monday, August 20, 2007

Paul Krugman: It's a Miserable Life

Paul Krugman on "new-fashioned bank runs":

It’s a Miserable Life, by Paul Krugman, Commentary, NY Times: Last week the scene at branches of Countrywide Bank, with crowds of agitated depositors trying to withdraw their money, looked a bit like the bank run in the classic holiday movie “It’s a Wonderful Life.” ...

But bank deposits up to $100,000 are protected by the Federal Deposit Insurance Corporation. Old-fashioned bank runs just don’t make sense these days.

New-fashioned bank runs, on the other hand, do make sense — and they’re at the heart of the current financial crisis. ...

Traditional banks ... lend out most of the money depositors place in their care, keeping only a fraction in cash. ... Banks get in trouble ... when some event, like a rumor that major loans have gone bad, leads many depositors to demand their money at the same time.

The scary thing about bank runs is that doubts about a bank’s soundness can be a self-fulfilling prophecy: a bank that should be safely in the black can nonetheless fail if it’s forced to sell assets in a hurry. And bank failures can have devastating economic effects. ...

That’s why bank deposits are now protected by a combination of guarantees and regulation. ... But these ... apply only to traditional banks. Meanwhile, a growing number of unregulated bank-like institutions have become vulnerable to the 21st-century version of bank runs.

Consider the case of KKR Financial Holdings..., a powerhouse Wall Street operator. KKR Financial raises money by issuing asset-backed commercial paper ... used by large investors to temporarily park funds — and invests most of this money in longer-term assets. So the company is acting as a kind of bank, one that offers a higher interest rate than ordinary banks...

It sounds like a great deal — except that last week KKR Financial announced that it was seeking to delay $5 billion in repayments. That’s the equivalent of a bank closing its doors because it’s running out of cash.

The problems ... are part of a broader picture in which many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.

On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick.

The problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to ... old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks.

Now, sometimes symbolic gestures are enough. The Fed’s surprise quarter-point interest rate cut ... at the height of the crisis caused by the implosion of the hedge fund Long-Term Capital Management, was similarly a case of providing money where it wasn’t needed. Yet it helped restore calm to the markets, by conveying the sense that policy makers were on top of the situation.

Friday’s cut might do the same thing. But if it doesn’t, it’s not clear what comes next.

Whatever happens now, it’s hard to avoid the sense that the growing complexity of our financial system is making it increasingly prone to crises — crises that are beyond the ability of traditional policies to handle. Maybe we’ll make it through this crisis unscathed. But what about the next one, or the one after that?

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Previous (8/17) column: Paul Krugman: Workouts, Not Bailout
Next (8/24) column: Paul Krugman: Seeking Willie Horton

    Posted by on Monday, August 20, 2007 at 12:33 AM in Economics, Housing, Regulation | Permalink  TrackBack (1)  Comments (51)

          

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