There are many historical examples of financial fragility, where shocks that are small relative to the economy as a whole have a significant effect on the financial system. Kindleberger, for example, in his famous book Manias, Panics, and Crashes: A History of Financial Crises (1978, pp. 107-108) argues forcefully that the immediate cause of a financial crisis can be anything from a triviality to a refusal of credit to certain borrowers or a change of view that induces a significant actor to unload. He goes on to describe how a financial crisis spreads and tends to be self-amplifying. Specifically, in a financial crisis prices fall, expectations get reversed, and the movement gathers momentum. Moreover, to the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls for margin or cash, and to further liquidation. As prices continue to plummet, bank loans turn sour, and one or more of them fail, which may cause solvency problems not only to other players in the financial market but also in the wider economy. The credit system itself appears shaky and the race for liquidity is on. One only needs to look at the evidence from a number of countries, including Finland, to see that financial crises can be costly. However, as recent research has emphasized, the welfare costs of financial crises are associated with inefficient liquidation of assets and suboptimal risk-sharing, rather than crises per se. Macroeconomic research has often focused on mistakes in government policy as the root cause of financial crises, whereas microeconomic approaches emphasize the hows and whys of the financial system and view crises as just one aspect in the broader scheme of financial activity.
Where do banks or financial intermediation fit in all this? Recent research focuses on the fragility of banks' capital structures. Banks make loans to illiquid borrowers and provide liquidity on demand to depositors. A fundamental incompatibility between the two activities seems to exist in the sense that depositors' demands for liquidity may occur at an inconvenient time and force fire-sale liquidations of illiquid assets. Furthermore, because depositors are served in sequence, the prospect of fire sales may precipitate self-fulfilling runs on banks. Several studies have emphasized that banks can resolve the liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost and buffer firms from the liquidity needs of their investors. However, a bank necessarily has a fragile capital structure, subject to bank runs, if it is to perform these functions. That is, banks need to choose a capital structure that will trigger a financial crisis if the bank should attempt to get concessions from depositors, or if it is anticipated that the bank will not deliver on its promised payments. An issue that naturally arises in this context concerns the nature of the relationship between banks' liquidity and incentives to take credit risk, as well as the contribution of the link - if that there is one - between banks' liquidity outlook and risk-taking behaviour to bank runs and wider financial crises. In his forthcoming Bank of Finland discussion paper 'Bank runs, liquidity and credit risk' Jukka Topi addresses these issues by constructing a theoretical model of a bank that enables him to analyze the interaction between a bank's liquidity outlook and incentives to take credit risk and to evaluate how the interplay between the two could contribute to bank runs. A key observation in Topi's analysis is that a comfortable liquidity outlook for a bank, in particular, may adversely affect the bank's incentives to monitor its credit risks. He incorporates endogenous credit risk monitoring of banks' credit customers into a model where banks face potential liquidity problems and incur credit losses. In the model, Topi focuses on cases where bank runs (liquidity crises) may be caused either by liquidity shocks alone or by combinations of liquidity shocks and credit losses, depending on the state of the economy. Consequently, the model allows specifically for the possibility that aggregate liquidity shocks cause bank runs by generating excessive asset price volatility, possibly in combination with weak economic fundamentals. Topi's analysis thus combines and extends a number of recent theoretical exercises, especially those of Allen and Gale, who have done much research on financial crises, financial intermediaries, liquidity and asset prices.
Topi gets some very interesting results. First of all, he shows that if banks run into severe liquidity problems, their incentives to monitor credit customers are generally weak. By implication, then, a higher probability of large bank-specific liquidity shocks encourages banks to increase their monitoring efforts. Secondly, a higher probability of adverse aggregate liquidity shocks that are sufficiently large to generate nontrivial downward movements in asset prices will reduce banks' monitoring activities. The intuition here is that monitoring cannot protect banks from the effects of sizable adverse aggregate liquidity shocks, which operate through asset price collapses, so that ex ante monitoring becomes less warranted in the face of adverse aggregate liquidity shocks. Consequently, banks' perception of an increasing likelihood of systemic crisis may weaken their incentives to monitor credit customers, which could in turn precipitate a crisis. The distinction Topi draws between bank-specific and aggregate liquidity shocks is particularly important, as these shocks have opposite implications for banks' monitoring incentives. An adverse shock of the former type strengthens monitoring incentives, whereas a negative aggregate liquidity shock weakens them. Topi's analysis gains additional importance from being able to deliver policy implications from banks' risk-taking behaviour in different liquidity environments. To take an example, the process of securitization has made banks' assets more liquid, which reduces the need to rely on sales of illiquid assets to meet liquidity obligations. Consequently, Topi's analysis suggests that securitization tends to weaken banks' incentives to monitor credit risks. For the conclusion of his analysis to hold, one needs to emphasize, as Topi does, that bank runs are caused predominantly by a combination of liquidity and credit problems. This is by no means counterintuitive, but more research is needed in this area. Topi's contribution is certainly important and highly interesting, which should encourage researchers to follow up on this initiative. |