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.

Some brief thoughts on QE2

  • Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface:  put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis.  Banks do not just borrow short and lend long; they also borrow safe and lend risky.
  • Liquidity is not uniform over the duration-instantaneous-default-risk space.   Liquidity is not even monotonic over the duration-instantaneous-default-risk space.
  • There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.
  • By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.
  • Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.
  • It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).
  • Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot.  I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.

Negative interest rates on US government debt and Brad DeLong (Updated)

The interest rates on US government debt has turned negative (again) as a result of the enormous flight to perceived safety.  I guess they’ll be able to fund their gargantuan bailouts more easily, at least.

Brad DeLong has written a short and much celebrated essay (available on Cato and his own site) on the financial crisis and (consequently) why investors currently love government debt and hate everything else.  I’ll add my voice to those suggesting that you read the whole thing.  Here is the crux of it:

[T]he wealth of global capital fluctuates … for five reasons:

  1. Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth.
  2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth.
  3. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.
  4. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.
  5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

Some people have criticised Brad for his characterisation of the liquidity discount, suggesting that he has confused it with the (pure) rate of time preference.  I don’t think he is confused.  Firstly because he’s a genuine expert in the field and if he’s confused,  we’re in big trouble; and secondly because the two concepts are interlinked.

The liquidity discount is that an inability to readily buy or sell an asset – typically evidenced by low trading volumes and a large bid/ask spread – reduces it’s value.

The pure rate of time preference is a measure of impatience.  $1 today is preferred over $1 tomorrow even if there is no inflation. [Update: see below]

The two are linked because if you want to sell assets in an illiquid market, you can either sell them at a huge discount immediately or sell them gradually over time.  The liquidity discount is (presumably) therefore a monotonically increasing function of the pure rate of time preference for a given level of liquidity.

Minor update:

A more correct illustration of the pure rate of time preference would be to say:

Suppose that you could get a guaranteed (i.e. risk-free) annual rate of return of 4% and there is no inflation.  A positive pure rate of time preference says that $1 today is preferred over $1.04 in a year’s time.