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Friday, August 10, 2007

"A New Kind of Bank Run"

Floyd Norris makes a good point about modern bank runs, or something just like them. The problem is that entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs. Here's how it works.

Hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market.

But like a bank who lends out most of the deposit it receives, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio. Thus, unless it has substantial cash reserves on-hand (part of the scramble now is to build cash reserves), when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems get worse as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

I see Brad DeLong has noted this as well in " Paul Krugman Recommends Floyd Norris Today," so I'll send you there to read the Norris article.

    Posted by on Friday, August 10, 2007 at 11:34 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (20)


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