Will a fragile banking system survive future runs? – Lawrence Schmidt

Lawrence Schmidt, Assistant Professor, Finance

From Barron’s. 

Events surrounding the failure of Lehman Brothers 10 years ago nearly brought down the world’s financial system. While much of the dust has settled, economists and policy makers still seek to better understand the forces that led a set of seemingly small losses on mortgage-backed securities tied to the U.S. housing market to trigger the worst global financial crisis since the Great Depression.

A strong candidate is the series of “runs”—large-scale, rapid withdrawals of short-term funding—that took place throughout 2007-08. The most dramatic run occurred on money market funds (MMFs) immediately following Lehman’s collapse. In a week, investors withdrew more than $300 billion from this market. This figure likely would have been larger had the Treasury not taken the unprecedented step of offering temporary guarantees to MMFs.

What causes runs? One economic theory posits that runs are the result of, and exacerbated by, investors’ self-fulfilling beliefs about other investors’ actions. The nature of banking is fragile. The bank keeps cash on hand to meet depositors’ daily needs, but it will lose money and may fail if it runs out of cash and is faced with the difficult task of selling its loans on short notice. Suppose, though, a depositor is worried a “run” might take place. If she believes that others are asking for their money back she is incentivized to do the same. First out wins; last out loses. If, however, others are not in a panic, that depositor will wait it out and the bank survives.

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Simon Johnson: Is Europe on the Verge of a Depression, or a Great Inflation?

MIT Sloan Prof. Simon Johnson

From the New York Times

The news from Europe, particularly from within the euro zone, seems all bad.

Interest rates on Italian government debt continue to rise. Attempts to put together a “rescue package” at the pan-European level repeatedly fall behind events. And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

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"Can Goldman Sachs Fail?"–Simon Johnson at the INET Conference, Bretton Woods

MIT Sloan Prof. Simon Johnson

“Who in the room thinks that if Goldman Sachs hit a rock, a hypothetical rock — I’m not saying they have, I’m not saying they will — today, who here thinks they would be allowed to fail, like Lehman Brothers did, unimpeded by any government bailout, starting Monday morning? Can Goldman Sachs fail?”

“I’ve asked this question around the country and only one person has ever raised his hand. It was in New York. He had a big short position in Goldman stock. That’s New York.

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