Lucas and Stokey: Liquidity Crises

I have talked quite a bit about how the financial crisis can be viewed as a traditional bank run in the non-traditional financial sector, the repo market in particular, and how, despite Dodd-Frank, we are still vulnerable to the non-traditional bank run problem. I've also talked about deposit insurance for firms engaged in maturity transformation as one potential way to reduce the likelihood of bank runs in the non-traditional system, and how fees and regulation can be used to offset the moral hazard problems that come with deposit insurance.

So it's nice to see agreement with these ideas. In a new (surprisingly non-mathematical) paper, Robert Lucas and Nancy Stokey talk about how to build a theoretical model of liquidity crises, and use these ideas to examine how deposit insurance, regulation, and other policies can reduce, but not fully eliminate, the likelihood of a liquidity crises in the future:

Understanding sources and limiting consequences: A theoretical framework, by Robert E. Lucas and Nancy L. Stokey, May 2011: Abstract Liquidity crises that induce or exacerbate deep recessions, as in 1930 or 2008, are situations in which individuals and firms want to build holdings of liquid assets. Heightened risk, or a perception of it, substantially increases demand for these assets. This reduces the supply available for normal transactions, leading to production and employment declines.

What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market. Massive lending by the Fed resolved the financial crisis, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.

In this essay, we first sketch theoretical ideas that bear on the sources of liquidity crises: bank runs, sunspots and contagion effects, and the moral hazard problem created by deposit insurance. We then describe the repo market, and argue that these theoretical concepts are useful for understanding that market as well.

We conclude with several lessons for regulatory reform and for the role of Federal Reserve policy in coping with future liquidity crises:

• Bank regulation can reduce the likelihood of liquidity crises, but cannot eliminate them entirely.
• During a liquidity crisis, the Fed should act as a lender of last resort.
• The Fed should announce its policy for liquidity crises, explaining how and under what circumstances it will come into play.
• Deposit insurance is part of the answer, but has a limited role.
• The Fed’s lending in a crisis should be targeted toward preserving market liquidity, not particular institutions.

Introduction It is hard to imagine better-motivated legislation than the Dodd-Frank Act, to date the one measure directed at preventing future financial crises. Yet it is hard to find an economist who argues that Dodd-Frank represents any appreciable progress toward this goal, nor is there anything like a consensus among its critics on what legislation should supplement or replace it. Economists cannot yet offer a complete, agreed-upon theoretical framework for thinking about liquidity crises, about the forces that precipitate them or exacerbate them or both.[1] Nevertheless, in our view, many of the main elements are in place. In this essay, we first describe these elements and then discuss how they might be combined to guide legislators and regulators.

Our interest here is in liquidity crises that induce or exacerbate deep recessions, as in 1930 or 2008. These crises are situations in which individuals and firms want to build up their holdings of liquid assets, cash and other securities that are close to cash in the sense that they can be exchanged for cash easily and at a predictable price. These assets have a special role because they are used, indeed required, for carrying out transactions. Heightened risk, or a perception of heightened risk, substantially increases the demand for these assets. This increase in demand has the effect of reducing the supply available to carry out the normal flow of transactions, leading to a reduction in production and employment.

What events are excluded by this definition? The stock market crash of 1929 and the dotcom crash of 2000 are two examples. These large, sudden changes in stock prices reflected changes in beliefs about future returns, but they did not have large, immediate effects on the inventories of cash or other liquid assets that individuals and firms wanted to hold, relative to the volume of their spending. Another example is the unexpected fall in house prices in 2007–08, which led to a reduction in construction activity. Housing construction is a large enough industry that this reduction would have shown up in a decline in overall GDP, but it would have been comparable in size to other recessions of the postwar era. (Of course, mortgage-backed securities, marketed as liquid assets, did play a central role in the financial crisis, and that role will be discussed below.)

The events that followed the failure of Lehman Brothers in September of 2008 were not a modest recession. The spending declines in the fourth quarter of 2008 and the first quarter of 2009 sent U.S. gross domestic product (GDP) from 3 percent or 4 percent below trend to 8 percent or 9 percent below, where it has remained ever since. Housing was only a tangential factor in this decline.

We will argue here that what happened in September 2008 was a kind of bank run. Creditors of Lehman Brothers and other investment banks lost confidence in the ability of these banks to redeem short-term loans. One aspect of this loss of confidence was a precipitous decline in lending in the market for repurchase agreements, the repo market. Massive lending by the Fed resolved the financial crisis by the end of the year, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.

In this essay, we first sketch several theoretical ideas that bear on the sources of liquidity crises: bank runs, sunspots and contagion effects, and the moral hazard problem created by deposit insurance. We then describe the repo market and argue that these concepts are useful for understanding that market as well. We then draw some conclusions for regulatory reform and for the role of Federal Reserve policy in coping with future liquidity crises. ...

Update: I meant to highlight this as well:

... Time consistency requires that no upper bound be placed on crisis lending. The guidelines we have for monetary policy, whether stated in terms of monetary aggregates or interest rates, are directed at long-term objectives and are no help in a liquidity crisis. After the Lehman failure in the fall of 2008, the Fed expanded bank reserves from $40 billion to $800 billion in three months, surely exceeding by far any limit that would have been imposed in August. Even with this decisive response, spending declined sharply over next two quarters.

Because crises occur too rarely for the ex ante formulation of useful quantitative rules, the Fed should have considerable discretion in times of crisis. Nevertheless, because policies should be predictable, the Fed should describe the indicators it will use to decide when lending has reached a sufficient level. ...