We use the German Crisis of 1931, one of the largest bank runs in financial history, to study how depositors behave in the absence of deposit insurance. We find that banks lose on average around 25% of their overall deposit funding during the run and that there is an equal outflow of retail and non-financial wholesale deposits from both ex-post failing and surviving banks. This implies that regular depositors are unable to identify failing banks. In contrast, the interbank market precisely identifies which banks will fail: the interbank market collapses for failing banks entirely but it continues to function for surviving banks, which can borrow from other banks in response to deposit outflows. We argue that since regular depositors appear uninformed it is unlikely that deposit insurance would exacerbate moral hazard. Instead, interbank depositors are best positioned for providing “discipline” via short-term funding.
The financial crises of the last twenty years brought new economic concepts into classrooms discussions. This article introduces undergraduate students and teachers to seven of these models: (i) misallocation of capital inflows, (ii) modern and shadow banks, (iii) strategic complementarities and amplification, (iv) debt contracts and the distinction between solvency and liquidity, (v) the diabolic loop, (vi) regional flights to safety, and (vii) unconventional monetary policy. We apply each of them to provide a full account of the euro crisis of 2010-12.
Is credit expansion a sign of desirable financial deepening or the prelude to an inevitable bust? We study this question in modern US data using a structural VAR model of 10 monthly-frequency variables, identified by heteroskedasticity. Negative reduced-form responses of output to credit growth are caused by endogenous monetary policy response to credit expansion shocks. On average, credit and output growth remain positively associated. “Financial stress” shocks to credit spreads cause declines in output and credit levels. Neither credit aggregates nor spreads provide much advance warning of the 2008-9 crisis, but spreads improve within-crisis forecasts.
This paper puts forward a manual for how to set up and solve a continuous time model that allows to analyze endogenous (1) level and risk dynamics. The latter includes (2) tail risk and crisis probability as well as (3) the Volatility Paradox. Concepts such as (4) illiquidity and liquidity mismatch, (5) endogenous leverage, (6) the Paradox of Prudence, (7) undercapitalized sectors (8) time-varying risk premia, and (9) the external funding premium are part of the analysis. Financial frictions also give rise to an endogenous (10) value of money.
This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.
This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.
We present a model in which an asset bubble can persist despite the presence of rational arbitrageurs. The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period. Since the derived trading equilibrium is unique, our model rationalizes the existence of bubbles in a strong sense. The model also provides a natural setting in which news events, by enabling synchronization, can have a disproportionate impact relative to their intrinsic informational content.
We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.