Danger Lurks in the Shadows
I've also complained about this off and on over the last year or so, and I'll feel better about the security of financial markets when the problem is finally addressed:
The Price of a Haircut, by Steve Landsburg: Yesterday I had the pleasure of attending a very good talk by Yale’s Gary Gorton on the origins of the financial crisis.
Gorton’s story is that this was a bank run, not substantially different from the bank runs that have always plagued capitalist economies. In this case, the run took place in the repo market, which is an unregulated (and largely unmonitored)... The repo market serves large institutions (e.g. Fidelity Investments or state governments) with a lot of cash on hand that they want to stash in an interest-bearing account for a day or two. So Fidelity deposits, say, a half-billion dollars at, say, Bear Stearns, just as you might deposit five hundred dollars at your local bank. One difference, though, is that your account at your local bank is insured, whereas Fidelity’s account at Bear Stearns is not — so Fidelity, unlike you, demands collateral for its deposit. Bear Stearns complies by handing over a half-billion dollars worth of bonds, of which Fidelity takes physical possession. The next morning, Fidelity withdraws its money and returns the bonds.
The problem comes in when rumors begin to spread that some bonds might be riskier than they appear, and Fidelity starts to worry that maybe Bear Stearns is picking particularly risky bonds to hand over. Therefore Fidelity demands more than a half-billion in bonds to guarantee its half-billion dollar deposit. If there’s, say, a 10% discrepancy between the deposit and the collateral, we say that Bear Stearns has taken a half-billion dollar haircut.
Because Bear Stearns has a fixed quantity of bonds on hand, and because all of its depositors are demanding haircuts, Bear Stearns can now accept fewer deposits than before. This means that Bear Stearns has less cash on hand. This makes depositors even more worried about the security of their deposits, which means they demand larger haircuts. The effects snowball until Bear Stearns collapses. ...
So what should we do about all this? Gorton, along with his colleague Andrew Metrick, argues that the repo market, like any banking market, is inherently susceptible to runs and therefore ought to be regulated. In this case, the regulations should focus on insuring the availability of sufficient high-quality collateral to keep depositors calm. Gorton observes that the existing policy responses to the crisis (e.g. the Dodd-Frank bill) do pretty much nothing to address this fundamental need. The Gordon/Metrick paper contains some specific proposals, which unfortunately Gorton never got to in yesterday’s talk. ...
Insuring the availability of high-quality collateral is not the only solution. For example, the shadow banking system could also be regulated much like the traditional banking system where limits on risk taking behavior and insurance fees are traded for deposit insurance (see here for an email from Metrick on this, the limits on risk-taking and the fees are intended to counter the moral hazard that arises with the deposit insurance). Regulators are supposedly working on this, and a solution involving collateral restrictions is the likely outcome, but so far the vulnerability persists.
Posted by Mark Thoma on Thursday, December 8, 2011 at 12:42 AM in Economics, Financial System, Regulation |
Permalink
Comments (18)
You can follow this conversation by subscribing to the comment feed for this post.