Academic

Why Was There A Bank Run in Alternative Banking?

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

All the big investment banks failed over the course of six months - or would have, if the Fed hadn't intervened.  And hedge funds and other shadow institutions also got killed, while insurance companies went for TARP funds, they were so pressed for solvency.

These institutions suffered something of a bank run during this period, as counterparties refused to trade with them.  Why?  No deposit insurance is a precondition, of course, but I'm not sure there is agreement about the precise form of the bank run, though it is pretty clear that there was one.  Repo market, commercial paper, CDSes, or just fire sales of assets due to asset depreciation....all of these funding mechanisms (CDSes may not be funding mechanisms, but humor me) dried up at roughly the same time.  At any rate, the investment banks and special investment vehciles borrow short and lend long, and they found that they couldn't borrow short from their counterparites all at the same time, meaning that they all started to go down at once.  There's a lot to say about timing here - when did everything go south?  Lehman, the start of the subprime meltdown, or what?  All of this, however, threatened the financial intermediaries so much because they were highly leveraged, and what capital they had was tied up in risky assets. 

You and I, simple depositors, don't have to worry about the solvency of our bank.  I don't care - and I wouldn't care even my credit union said that it had had a terrible quarter, or was putting all of my money into big bets at the dog track.  But the counterparties of the shadow banks had to worry about the solvency of their trading partners.  And they all lost confidence in the shadow banks at the same time, who, since they depend on short term money quickly fell apart.

The problem with sorting out what cased the loss of confidence in September, when things really went kerblooey (though they weren't easy before then), is that the month is overdetermined.  You could to an event study on the VIX or LIBOR, but it is hard to separate the Lehman news from the AIG news, from the "we're going to Capitol Hill" news from the "deposit window is open" news from the WaMu news from the Reserve Primary news.  I wonder if we'll ever know what really triggered the collapse - of course, it is possible to spook people with a range of bad news events that come close together, and perhaps that is what happened here.

Full post as published by Conglomerate on September 03, 2009 (boomark / email).