Wednesday, August 17, 2011

How to stop a European bank run

This piece from Joseph Cotterill on the FT Alphaville blog this morning reminded me of what I learned about bank runs from Gary Gorton's book.  It relates directly to what the Eurozone countries are trying to do to stave off a run on their banks.

From the 1860s to 1913, there was no U.S. central bank to be lender of last resort.  Banks formed "coalitions or clubs of banks" to coordinate in processing checks and to monitor one another's behavior.  During a bank run or panic (Gorton):
"banks would jointly suspend convertibility of deposits into currency...clearinghouse member banks joined together to form a new entity overseen by the Clearinghouse Committee...The clearinghouse would also cease the publicatoin of individual bank accounting information...and would instead only publish aggregate information of all the members...the clearinghouse issued new money, called clearinghouse loan certificates, directly to the public." 
So, the good banks and bad banks were all lumped behind a firewall, and no one knew who was bad or good; no depositor could redeem his deposit until the banks behind the firewall dealt with the problem, the panic subsided, and the firewall was taken down.  This created incentives for banks to behave well and not get risky in the first place or risk being kicked out of the coalition.  (Ironically, when the Fed was created in 1913 this practice became illegal and actually made the system less stable.)

Europe is now trying to do the same thing by eliminating individual country debt and only issuing joint Eurobonds.  Greece is experiencing the run, and rumors abound that maybe all the countries are doomed-- so Spain and France see their interest rates rise and CDS on their bonds also get more expensive as investors fear default.  This is just like a bank run, and a run is a self-fulfilling prophecy.

Like the banking coalition, the Eurobond proposal requires greater uniformity in the behavior of the individual members, lest they be kicked from the club.  So, European countries will have to adopt a much stronger fiscal union than before. (Think of the 50 U.S. states that all uniformly have balanced-budget requirements in their constitutions.) Fiscal unity is a prerequisite for a common currency, so this step should have been taken long ago if the euro experiment was to succeed.

It remains to be seen if all the countries will jump on board.  Just like the banking coalition, the fiscally sound countries hate the implicit subsidy to the weak countries, but it's necessary if their coalition is going to survive. If they don't adopt the measure, the Eurozone as we now see it is doomed.


John Nelson said...

Very interesting historical parallel. So if this a valid precedent, would we expect the Euro bonds to be converted back into country debt once the "run" is over? Or would there just be accounting behind the scenes that designated who was responsible for payments on specific issues?

JDTapp said...

I think the answer to your second question would be "yes," but you obviously couldn't have the heavy debtors paying the brunt of debt b/c that's the current problem. So, there would have to be equal sharing-- which would be a subsidy from strong to weak. That's my understanding of how it worked with the bank clearinghouse system.

I think in this case it could necessarily have to be a permanent solution, at least until it's proven over a long period of time that the Eurozone countries can keep their budgets in line with strict targets.

Others have proposed having a two-tiered system where single-country debt up to a certain percentage of GDP is shared via Eurobonds, anything over that is on the back of the individual country. But that, to me, is like a hole in the wall of the clearinghouse and would just continue the run.