Question:

The liquidity problems affecting money markets in 2007-08 have been described as“a run on repo”. Describe in detail how a bank run arises. Explain the liquidity problems that affected the money markets in 2007-08, drawing analogies between these and a traditional bank run. Throughout your essay take care to explain the nature of the financial instruments and markets you discuss.

Answer:

The entire world experienced a financial catastrophe during the year 2007-08 which affected even the developed nations like US, UK and others as well. Some of the nations are still not able to recover from the financial crisis though trying hardly for the same. Industry experts and scholars have compared this global financial crunch with the great depression that occurred in 1930s. The principle reason for comparing such global financial downturn is to properly identify, understand and prevent the factors in future that could create such financial crisis. The crisis during 2007-08 had a strong and adverse effect on the financial institutions at international level (Melvin and Norrbin, 2013). In this context, Chor and Manova (2012) expressed that prevalence of low interest rate in the United States before the global financial crisis led to bursting of housing bubble which further forced the banks to incur millions of dollars towards bad debts as a result of mortgage delinquencies. This clearly indicates that the commercial banks did not conduct appropriate credit examination of the individual customers or borrowers before extending credit. In other words, the commercial banks did not properly assess the capability of the individual borrowers to repay the loans. This makes the subprime mortgage market as one of the key triggers of the global financial crisis. In fact, the banking system itself seems to be responsible for the adverse impact of the global financial crunch. It seems that the financial crisis could have been easily avoided if the banks had conducted proper credit assessment of the borrowers. On the other hand, Fratzscher (2012) viewed that regulators can be held responsible for the low interest rates that prevailed prior to the financial downturn. The global recession had a drastic impact on a number of financial institutions and banks across the globe. A bank is also a part of the financial institution system that evidenced the impact of the financial crisis. Bank is a common place where customers Deposit money and also borrow funds in case of needs. Here, it is important to note that banks use only a fraction of the total deposits made by the public to advance loans that is not possible to sale at higher prices in the market.

Demand deposit is yet another major financial tool in this regard that requires critical discussion. Demand deposits issued by banks allow depositors to withdraw respective assets from the bank at any point of time (Yang, 2012). Here, liquidity refers to the ease and convenience with which the assets can be converted into cash at any specific time. In this context, Bénétrix et al. (2015) viewed that bank runs are usually caused by the mismatch in which bank deposits or liabilities are more liquid compared to the loans or assets. In this context, Scott and Wellons (2004) mentioned that bank run can be defined as the situation in which all the depositors withdraw funds from respective bank accounts at the same time for the fear that the banks might fail. Speculations are the principle cause for such bank runs though existence of other factors cannot be ignored as well. During the global recession in 2007-08, the leading bank Lehman Brothers of the US also suffered financial crisis which further raised awareness about bank runs. Bank runs can be highly dangerous and have a long-term impact on the financial condition of a bank. However,here it is interesting to note that while other banks were facing liquidity crunch due to withdrawal of deposits by the customers the Lehman Brothers experienced the crisis because of huge withdrawal of repurchase agreements known as repo. Hence the situation of Lehman Brothers is described as a run for repo. 

In the view of Bertaut et al. (2012), liquidity is one of the most vital functions of any commercial bank. Depositors can withdraw respective deposits and assets at any time and such withdrawal by a large number of depositors can create pressure on the liquidity position of the commercial banks. This requires commercial banks to have an asset that can be utilized at any point of time. This can help in fighting the uncertainties associated with the withdrawal of deposits by the consumers. The situation can be worse if commercial banks fail to generate adequate liquidity. This can also affect the money market which is a part of the entire financial market in which highly liquid assets and short-term securities are traded.It is important to note a bank is capable of creating and increasing liquidity even though the bank makes investment in illiquid assets (Rasmus, 2010). This phenomenon can be explained by a numerical example.

It is assumed that the concerned bank has no equity and that the total number of depositors in the bank is 100 at T0. These 100 depositors can be classified into two groups namely Group I and Group II. The Group I depositors make consumption at T1 whereas depositors in the Group II consume at T2. These assumptions are made only to make the example and calculation simpler. It is further assumed that all the depositors invest 1 unit each. It is the policy of the bank to provide r1 = 1.25 to the investors withdrawing at T1 whereas 55 out of total 100 investors make withdrawal at T1. Hence, it indicates that the concerned bank makes liquidation of 1.25*35 = 43.75 units at T1. Therefore, the remaining balance with the bank is 56.25 units calculated by deducting 43.75 from 100 that are expected to mature at T2. Here, it is important to understand that the worth of the total portfolio held by the bank at T1 is 1 * 100 = 100 units whereas the worth of the portfolio at T2 stands at 2 * 56.25 = 112.50. However, the rest of the 45 depositors need to be repaid. Thus, each of the depositors receives r2 = 1.73 which is calculated as (100-43.75)2 / 65. Per unit 1.73 is dependent on the remaining amount of investments worth 56.25 at T1. Therefore, it would not be inappropriate to state from the above observation that depositors prefer liquid assets over the illiquid ones. This can be attributed to the positive returns offered by the deposits as seen in the above example. In addition to this, demand deposits are also offered by commercial banks. These can be considered as the major reasons for people making investment in bank deposits. The customers of commercial banks make a large volume of deposits however only a fraction of the total deposits are used by such banks to offer loans and the balance of the deposits are maintained by banks as reserve. This concept is termed as fractional reserve banking. For example, it is assumed that all the depositors deposits money at the same time which is T0. It will be the practice of the bank to utilize these deposits to offer loans to the customers that will mature at T2. Therefore, the value of the loan offered by a bank is usually greater than that of the present value of the concerned loan. The difference in the financial value of the loan at the time of maturity of the loan indicates the income earned by the bank. In other words, this gap represents interest rate or interest income. It is interesting to note here that the depositors are not aware of the group type they would be at T0 however depositors are only aware of the group type at T1. This can be explained by the fact that Group II depositors need to wait till T2 until Group I depositors makes withdrawals at T1. This situation represents a good equilibrium. On the contrary, bank run or a bad equilibrium results if both Group I and Group II depositors withdraw at T1 as group II depositors might fear that everyone else would do so. In this context, Bishop (2004) expressed that it is not possible for a bank to predict the time when each depositor will withdraw deposits however it is a common assumption of all banks that all depositors would not make withdrawal at the same which causes a bank run. In other words, the banks do not have any concrete idea when each depositor will withdraw deposits but the same is only known to the depositors and this is one of the greatest challenges for any commercial bank.

The mechanism of a bank run can be better explained through a numerical example. Returns on a project is indicated by R1 = 1 and R2 = 2. The total fund at the disposal of the bank at T0 is 100 units because of 1 unit of deposits by all the 100 depositors. The bank provides r1 = 1.2 to those investors withdrawing at T1. The rest of the investments determine the return at r2 indicated by t2. The bank is thus required to pay 55 * 1.2 = 66 units to the depositors withdrawing funds at t1. The yield calculated at t2 is 68 which is obtained through (100-66)*2. This further results in a r2 of 1.5111 arrived at by dividing 68 by 45. It is assumed that the group II depositors are rational in nature and hence would wait till if feasible. The situation indicates a good equilibrium. On the contrary, if 75 depositors make withdrawals at t1 while the number of investors and the return rate remains unchanged then the bank needs to liquidate 1.2 * 75 = 90 units. Therefore, the yield at t2 is (100-90) * 2 = 20 resulting in a r2 of 0.80 per unit which is obtained by dividing 20 by 25. All the 100 depositors is expected to prefer t1 but it is not possible for the concerned bank to pay 1.2 * 100 = 120 units which creates chances of getting default as the bank has only 100 units of portfolio at t1. This situation indicates a case of bank run also known as a bad equilibrium. However, the bank provides r1 to group I depositors and r2 to group II depositors at the respective maturity date of t1 and t2. Here, it is important to note that the proceeds released by the bank at the maturity date is greater than the initial deposits made by the customers because the interest paid by the bank gets added to the initial deposits of the investors.