Avoiding Financial Crises

 On the recent Nobel Prize award for economics, Paul Krugman has some good thoughts on avoiding financial abysses.

What can be done to mitigate the risk of self-fulfilling panic? As Diamond and Dybvig noted, a government backstop — either deposit insurance, the willingness of the central bank to lend money to troubled banks or both — can short-circuit potential crises. Indeed, the mere knowledge that a backstop exists can often quell a bank run; no money need actually change hands.

But providing such a backstop raises the possibility of abuse; banks may take on undue risks because they know they’ll be bailed out if things go wrong. Case in point: the huge costs to taxpayers of bailing out irresponsible players during the savings and loans crisis in the 1980s. So banks need to be regulated as well as backstopped.

From an economic point of view, banking is any form of financial intermediation that offers people seemingly liquid assets while using their wealth to make illiquid investments.

This insight was dramatically validated in the 2008 financial crisis. Conventional banks were, for the most part, unaffected by the panic; there was no mass exodus from bank deposits. By the eve of the crisis, however, the financial system relied heavily on “shadow banking” — banklike activities that didn’t involve standard bank deposits. For example, many corporations had taken to parking their cash not in deposits but in “repo” — overnight loans using things like mortgage-backed securities as collateral. Such arrangements offered a higher yield than conventional deposits. But they had no safety net, which opened the door to an old-style bank run and financial panic.

a sort of meta point about the Diamond-Dybvig work: Once you’ve understood and acknowledged the possibility of self-fulfilling banking crises, you become aware that similar things can happen elsewhere.

Sure enough, when Mario Draghi, the president of the European Central Bank at the time, finally did provide a backstop in 2012 — he said the magic words “whatever it takes,” implying that the bank would lend money to the troubled governments if necessary — the spreads collapsed and the crisis came to an end