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A taxonomy of bank failures

I hereby present John’s Not Particularly Innovative Taxonomy Of Bank Failures ™.  In increasing order of severity:

Category 1) A pure liquidity crunch — traditionally a bank run — when, by any measure, the bank remains entirely solvent and cash-flow positive;

Category 2) A liquidity crunch and insolvent (assets minus liabilities excluding shareholder equity is negative) according to market prices, but solvent according to hold-to-maturity modeling and cash-flow positive;

Category 3) A liquidity crunch and insolvent according to both market prices and hold-to-maturity modeling, but still cash-flow positive;

Category 4) A liquidity crunch, insolvent and cash-flow negative, but likely to be cash-flow positive in the near future and remain so thereafter; and, finally,

Category 5) A liquidity crunch, insolvent and permanently cash-flow negative.

A category 1 failure is easily contained by a lender of last resort and should be contained: the bank, after all, remains solvent and profitable. Furthermore, a pure liquidity crunch, left unchecked, will eventually push a bank through each category in turn and, more broadly, can spill over to other banks. There need be no cost to society of bailing out a category 1 failure. Indeed, the lender of last resort can make a profit by offering that liquidity at Bagehot‘s famous penalty rate.

A category 2 failure occurs when the market is panicking and prices are not reflecting fundamentals. A calm head and temporarily deep pockets should be enough to save the day. A bank suffering a category 2 failure should probably be bailed out and that bailout should again be profitable for whoever is providing it, but the authority doing to bailing needs be very, very careful about that modeling.

For category 1 and 2 failures, the ideal would be for a calm-headed and deep-pocketed private individual or institution to do the bailing out. In principle, they ought to want to anyway as there is profit to be made and a private-sector bailout is a strong signal of confidence in the bank (recall Warren Buffett’s assistance to Goldman Sachs and Bank of America), but there are not many Buffetts in the world.

Categories 3, 4 and 5 are zombie banks. Absent government support, the private sector would kill them, swallow the juicy bits and let the junior creditors cry. If the bank is small enough and isolated enough, the social optimum is still to have an authority step in, but only to coordinate the feast so the scavengers don’t hurt each other in the scramble. On the other hand, if the bank is sufficiently important to the economy as a whole, it may be socially optimal to keep them up and running.

Holding up a zombie bank should optimally involve hosing the bank’s stakeholders, the shareholders and the recipients of big bonuses. Whether you hose them a little (by restricting dividends and limiting bonuses) or a lot (by nationalising the bank and demonising the bonus recipients) will depend on your politics and how long the bank is likely to need the support.

For a category 3 failure, assuming that you hold them up, it’s just a matter of time before they can stand on their own feet again. Being cash-flow positive, they can service all their debts and still increase their assets. Eventually, those assets will grow back above their liabilities and they’ll be fine.

For a category 4 failure, holding them up is taking a real risk, because you don’t know for certain that they’ll be cash-flow positive in the future, you’re only assuming it. At first, it’s going to look and feel like you’re throwing good money after bad.

A category 5 failure is beyond redemption, even by the most optimistic of central authorities. Propping this bank up really *is* throwing good money after bad, but it may theoretically be necessary for a short period while you organise a replacement if they are truly indispensable to the economy.

Note that a steep yield curve (surface) will improve the cash-flow position of all banks in the economy, potentially pushing a category 5 bank failure to a category 4 or a 4 back to a 3, and lowering the time a bank suffering a category 3 failure will take to recover to category 2.

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Understanding the credit crisis

Steve Waldman has done up a brilliant explanation of the credit crisis:

Alice, Bob, and Sue have ten marbles between them. Whenever one kid wants another kid to take over a chore, she promises a marble in exchange. Alice doesn’t like setting the table, so she promises Bob a marble if he will do it for her. Bob hates mowing the lawn, but Sue will do it for a marble. Sue doesn’t like broccoli, but if she says pretty please and promises a marble, Bob will eat it off her plate when Mom isn’t looking.

One day, the kids get together to brag about all the marbles they soon will have. It turns out that, between them, they are promised 40 marbles! Now that is pretty exciting. They’ve each promised to give away some marbles too, but they don’t think about that, they can keep their promises later, after they’ve had time to play with what’s coming. For now, each is eager to hold all the marbles they’ve been promised in their own hands, and to show off their collections to friends.

But then Alice, who is smart and foolish all at the same time, points out a curious fact. There are only 10 marbles! Sue says, “That cannot be. I have earned 20 marbles, and I have only promised to give away three! There must be 17 just for me.”

But there are still only 10 marbles.

Suddenly, when Bob doesn’t want to mow the lawn, no one will do it for him, even if he promises two marbles for the job. No one will eat Sue’s broccoli for her, even though everyone knows she is promised the most marbles of anyone, because no one believes she will ever see those 17 marbles she is always going on about.

…

Almost whatever happens, the trading of chores, so crucial to the family’s tidy lawns and pleasant dinners, will be curtailed for some time. Perhaps some trading will occur via exchange of actual marbles, but this will not be common, as even kids see the folly of giving rare glass to people known to welch [sic] on their promises. It makes more sense to horde.

A credit crisis arises when many more promises are made than can possibly be kept, and disputes emerge about how and to whom promises will be broken. It’s less a matter of SIVs than ABCs.

Steve later gives an example of the three balance sheets that count produce the situation he described:

Alice (equity: -19)

Assets Liabilities
Physical marbles: 4  
Marbles promised from Bob: 0 Marbles owed to Bob: 7
Marbles promised from Sue: 2 Marbles owed to Sue: 18
Total Assets: 6 Total Liabilities: 25

Bob (equity: 12)

Assets Liabilities
Physical marbles: 6  
Marbles promised from Alice: 7 Marbles owed to Alice: 0
Marbles promised from Sue: 1 Marbles owed to Sue: 2
Total Assets: 14 Total Liabilities: 2

Sue (equity: 17)

Assets Liabilities
Physical marbles: 0  
Marbles promised from Alice: 18 Marbles owed to Alice: 2
Marbles promised from Bob: 2 Marbles owed to Bob: 1
Total Assets: 20 Total Liabilities:


I really enjoy this sort of analogy, because I think that a lot of policy decisions can be enlightened by considering the actors to be individual people rather than the organisations (or entire countries) that they are. So what should Mum and Dad do? Steve also observes the three main possibilities:

Perhaps Mom and Dad will decide that the best thing to do is just buy some more marbles, so that all the children can make good on their promises. But that would mean giving Alice 19 marbles, because she was laziest and made the most promises she couldn’t keep, and that hardly seems like a good lesson. Plus, marbles are expensive, and everyone in the family would have to skip lunch for a week to settle Alice’s debt.

Perhaps the children could get together and decide that an unmet promise should be worth only a quarter of a marble, so that everyone is able to keep their promises after all. But then Sue, the hardest working, would feel really ripped off, as she ends up with a much more modest collection of marbles than she had expected. Perhaps Bob, the strongest, will simply take all the marbles from Alice and Sue, and make it clear than none will be given in return, and that will be that.

Or, perhaps Alice and Bob could do Sue’s chores for a while in addition to their own, extinguishing one promise per chore. But that’s an awful lot of work, what if they just don’t want to, who’s gonna force them? What if they’d have to be in servitude to Sue for years?

The ultimate answer is a combination of all three: Buy some extra marbles (but not all 30), declare each promise to be worth less than a full marble (but not as little as a quarter) and force Alice, and to a lesser extent Bob, to do some chores for Sue (but not full replacement).

The real question is this: Whose fault is it that Alice was able to continue running up debts she couldn’t pay? Should mum and dad been watching all along to make sure that everybody played nicely? Or should Bob and Sue have had more sense when Alice promised to pay them?

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Search costs

There is a bank on campus at LSE. It has four cashpoints (as the Poms call them, or ATMs to the rest of us), arranged like this:

ATMs at LSE

There is frequently a queue to use the cashpoints at A and D, but almost never at B or C. They are, at most, four metres from cashpoint A, but at all times they either have no queue, or if they do, it is always shorter than that for A or D (since they are next to each other, they typically produce a single queue). This includes those times when it is raining, despite the fact that B and C are under cover, while A and D are exposed.

This poses a puzzle. Why do B and C not get used more? Why are the queues at A and D longer than they need to be?

Part of the answer lies in this next bit of information:

B and C are readily visible from the street if you stand in front of the entrance, but they are not immediately visible from a little way along the street. In particular, they are not visible from the queues that build up for cashpoints A and D. Cashpoint A is not immediately obvious when looking up from the main street.

The standard economic answer would therefore involve search costs and cut-off thresholds. There is a time (and annoyance) cost involved in checking other cashpoints and there is no guarantee that you will find one with a shorter queue. Provided that the time cost of staying with your current queue is below your reservation cost (the threshold), it’s optimal for you to stay where you are.

Most people that use D are passers-by that just happened to be walking along the main street and won’t be aware that A, B or C exist. For these people, the believed search costs could be quite high (there is not another bank in the immediate area) and the prior belief on the probability of finding a cashpoint with a shorter queue quite low (since people generally want to use cashpoints at the same time).

But the people that use A, B and C are generally all LSE staff and students who are well aware of all four cashpoints. For those waiting at A, the search cost for checking B and C is vanishingly small and for the sufficiently observant of them, their prior beliefs on the queue length at B and C will be that they are quite likely to be shorter.

So why don’t they do it?