Gorton the maze of banking; history, theory, crisis (2015)

The Maze of Banking The Maze of Banking History, Theory, Crisis GARY B GORTON Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, c Oxford University Press 2015 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer CIP data is on file at the Library of Congress ISBN 978–0–19–020483–9 Printed in the United States of America on acid-free paper For Nic and Dan CONTENTS Acknowledgments xi 1 Introduction (June 2, 2014) PART I Bank Debt “Financial Intermediaries and Liquidity Creation,” with George Pennacchi, Journal of Finance 45, no (March 1990): 49–72 43 “Reputation Formation in Early Bank Note Markets,” Journal of Political Economy 104, no (April 1996): 346–97 69 “Pricing Free Bank Notes,” Journal of Monetary Economics 44 (1999): 33–64 122 “The Development of Opacity in U.S Banking,” Yale Journal of Regulation, forthcoming 154 PART II Banking Panics “Bank Suspension of Convertibility,” Journal of Monetary Economics 15, no (March 1985): 177–93 183 “Banking Panics and Business Cycles,” Oxford Economic Papers 40 (December 1988): 751–81 200 “Clearinghouses and the Origin of Central Banking in the United States,” Journal of Economic History 45, no (June 1985): 277–83 234 “The Joint Production of Confidence: Endogenous Regulation and Nineteenth Century Commercial Bank Clearinghouses,” with Don Mullineaux, Journal of Money, Credit and Banking 19, no (November 1987): 458–68 241 viii Contents 10 “Bank Panics and the Endogeneity of Central Banking,” with Lixin Huang, Journal of Monetary Economics 53, no (October 2006): 1613–29 254 11 ‘Liquidity, Efficiency, and Bank Bailouts,” with Lixin Huang, American Economic Review 94, no (June 2004) 273 PART III What Banks do? 12 “The Design of Bank Loan Contracts,” with James Kahn, Review of Financial Studies 13 (2000): 331–64 317 13 “Universal Banking and the Performance of German Firms,” with Frank Schmid, Journal of Financial Economics 58 (2000): 3–28 354 14 “Bank Credit Cycles,” with Ping He, Review of Economic Studies 75, no (October 2008): 1181–214 407 PART IV Change in Banking 15 “Corporate Control, Portfolio Choice, and the Decline of Banking,” with Richard Rosen, Journal of Finance 50, no (December 1995): 1377–420 457 16 “Banks and Loan Sales Marketing Nonmarketable Assets,” with George Pennacchi, Journal of Monetary Economics 35, no (June 1995): 389–411 504 17 “Special Purpose Vehicles and Securitization,” with Nicholas S Souleles, chapter in The Risks of Financial Institutions, edited by Rene Stulz and Mark Carey (University of Chicago Press, 2006) 528 PART V The Crisis of 2007–2008 18 “Questions and Answers about the Financial Crisis,” prepared for the U.S Financial Crisis Inquiry Commission 583 19 “Collateral Crises,” with Guillermo Ordoñez, American Economic Review 104, no (February 2014): 1–37 599 660 THE CRISIS OF 2007–2008 crises Kiyotaki and Moore (1997) and Bernanke and Gertler (1989) are now— since the crisis—cited, ex post, as examples of the attention paid to financial frictions in macroeconomics But, these models were not part of the formal modeling approach used in policy circles Models addressing issues of the persistence of temporary shocks and the amplification of shocks are important But, they cannot display crises A macro model that can display a financial crisis is a distinct undertaking from a model which displays persistence of temporary shocks, real effects shocks to net worth, or from other financial frictions As emphasized above, a crisis is a singular event, not the result of a large shock The notion of “frictions” arises when the benchmark model, the neoclassical growth model and complete markets cannot replicate important features of reality In order to induce this model to replicate various features of reality one then adds “frictions.” There is a great deal of discretion here in modeling The researcher chooses from a smorgasbord of “frictions” to add in order to obtain the desired “result.” The problem really is that the benchmark model misses the fact that private money is inherent in market economies This was first noted a long time ago, for example, by Martin Shubik (1975), but the current crisis strongly suggests that this approach has reached a dead end That bank debt is vulnerable to runs in market economies is a fact, like demand curves sloping downward It is not a “friction” in that sense, but a fundamental feature of market economies Once again, it is clear that there is much research to There are a number of (to me, anyway) exciting directions that are developing in macroeconomics Examples include Brunnermeier and Sannikov (2010), He and Krishnamurthy (2012), and Maggiori (2012) These models incorporate financial sectors and not focus on steady states That is, they not focus on linearized system dynamics around the steady state So, they can display crisis-like behavior On the other hand, while they incorporate financial sectors, the crisis is a big shock The dynamics are triggered by a large shock which reduces the capital of banks, causing them to have to sell assets While this may be viewed as a reduced form for a bank run, it is not, in fact, a run Also see Boissay, Collard, and Smets (2012) 20.3.3 Final Thoughts President Obama’s chief of staff Rahm Emanuel observed during the crisis that: “You never want a serious crisis to go to waste,” meaning that it is an opportunity to address long overdue problems in a major way This is good advice for economists as well The crisis revives old issues and raises new issues The human toll from the crisis means that this is quite an urgent task In order to address these issues documenting what happened during the recent financial crisis is critical to our understanding and remains the first task Reflections on the Financial Crisis 661 The recent crisis emphasizes a number of points These are worth repeating First, the recent crisis was a bank run, in the money markets Secondly, the recent crisis emphasizes that a financial crisis is a distinct, regime switch-type, event It was clearly different, worse, larger, than usual recessions Thirdly, it showed (again) that crises recur in market economies Fourthly, the crisis also showed that bank money without the common pool problem is vulnerable to runs Fifth, it poses the question of why crises not occur during certain periods What regulation was successful? Sixth, the fact that basic institutions in the economy—banks, bank money—could transform largely without notice, means that our measurement systems are suspect These are important lessons The first two points are the core of the concept of a crisis, while the third point emphasizes the fundamental nature of crises in market economies The theory of crises needs to address the fourth point because, as an empirical matter, all forms of bank money are vulnerable We know little about why there are long periods of quiet, about what bank regulations are effective or whether it was just good luck that produced these periods Finally, producing measurement systems that keep up with change are paramount I have emphasized that empirical documentation of the crisis is critical, and that it is difficult for outsiders who did not see the crisis to know what to document Finding data is hard, but crucial Theory cannot be built on newspaper stories REFERENCES Allen, Franklin and Douglas Gale (2000), “Financial Contagion,” Journal of Political Economy 108, 1–33 Angeletos, George-Marios and Ivan Werning (2006), “Crises and Prices: Information Aggregation, Multiplicity, and Volatility,” American Economic Review 96 (5), 1720–36 Atkeson, Andrew G (2001), “Rethinking Multiple Equilibria in Macroeconomic Modeling: Comment,” in NBER Macroeconomics Annual 2000, ed Ben Bernanke and Kenneth Rogoff (MIT Press; 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78, 79, 95, 96, 97, 110, 532, 546, 552, 553–555, 598, 603, 656 Asian crisis 274, 296, 641 Asset-backed commercial paper (ABCP) 17, 21, 32–34, 171–172, 541, 652 Asset-backed securities (ABS) 17, 31–32, 35, 171–173, 543, 559–561, 564, 567, 568 opacity of 173 Asset substitution 323, 326, 329, 345 Bagehot, Walter 255 Bailouts 23–24, 173, 274–276, 292–297, 300–301 around the world 274 costs of 274–275 Bank bailouts, see bailouts branching 12, 78, 95, 97, 123, 126, 127, 133, 146, 148, 256, 258, 261–265, 272, 365, 644 charter value 29, 30, 460, 475, 490 decline in profitability in the 1980s 457–458 failures 11, 19, 29, 30, 78, 123, 256, 260, 265, 458, 459, 647 industrial organization 22, 256, 272, 644 lending decisions 462–466 lending or credit standards 27, 407–409 liquidity provision 45 loan sales and, see loan sales managerial entrenchment 467, 470 opacity, see opacity of banks private benefits of control 462, 463, 465–466 renegotiation of loans 25, 26, 281, 283, 285, 287, 298, 299, 317, 318–320, 324–328, 331–339 rivalry in credit card loans 419–428 runs, see bank runs suspension of convertibility, see suspension of convertibility Bank debt, see debt Bank of England 255, 644 Bank of Indiana 133 Bank of New York 245 Bank of Tennessee 134–136 Bank of Virginia 159 Bank loans 25–26, 317 collateral 319, 323, 324 commercial and industrial loans, see commercial and industrial loans covenants 25, 318, 324, 326, 344 credit card lending, see credit card loans distinct from corporate bonds 25, 343–344 loan sales, see Loan sales monitoring of borrowers 269, 318 pricing 339, 342 renegotiation 318–319, 324, 337–339 seniority of 317, 345 loan liquidation 321, 324–325, 336–337 renegotiated interest rates 331–334 670 Bank notes 6, 14, 75–77, 157–158, 236, 243–245, 652 adverse selection 95 counterfeit 10, 13, 76, 93–95, 236, 244 discounts 12, 14, 81–86, 134, 158 embedded put option 12, 124, 139 excess entry discount 95–97 market 13, 125 pricing 122, 139–144, 150 redemption 83 reporter, see Van Court’s Counterfeit Detector and Bank Note List secondary market 7, 14, 16, 77, 157, 158, 162, 236, 241, 244–245, 249, 252, 286 Bank runs 2, 4, 18, 164, 165, 168, 176, 177, 178, 197, 238, 256, 262, 266, 642–645, 649, 651, 652, 654, 658 clearinghouses and 21–22, 157, 171 credit booms and 600 definition of 18, 21, 168, 261, 648 Diamond-Dybvig and, see Diamond and Dybvig model different forms of debt and 21, 647 financial crisis of 2007–2008 173, 659 observability of 640–641 repo and 173 shadow banking and, see shadow banking stock prices and 165 suspension of convertibility and 639 triggered by information 17, 20 vulnerability of debt 1, 156 Bank stocks 164–166 Bank suspension of convertibility, see suspension of convertibility Banking panics, bank runs 203, 205, 249, 256–257 Bankruptcy remoteness, see securitization Banzhaf Index 364 Baumol-Tobin model 207 Bernanke, Ben 2, 3, 173, 174, 598, 641 Bernanke-Gertler (1989) model 657, 658 Index Black-Scholes option pricing model 12, 82, 124, 144 Block share-holdings of banks, see German universal banking Branch banking 12, 95, 123, 127, 148, 256, Brown, William Wells 10, 11 Burns, Arthur 19 Business cycles 19, 97, 183, 203, 206, 221, 222, 225, 227, 228, 229, 231, 407, 422, 434, 640, 643, 646–647, 650 Call Reports 29, 213, 420, 477, 482, 506, 560 Calomiris, Charles 18, 78, 79, 95, 127, 644 Canadian banking 256, 265–266 Central bank 23, 171, 255–256, 272, 505, 626, 644, 648 bailouts and 24, 640 Canadian 257 expectations and 18, 639, 643, 645 information and 177 panics and 20–21 Certified checks 22, 169–171, 211 Charter value (of banks), see bank Clearinghouses 16, 21–23, 27, 163, 168–171, 266 central bank-like 21–22, 157, 171, 235, 237–240, 243 loan certificates, see clearinghouse loan certificates loan committee 170, 249 monitoring 246–248 response to panics 237–240 suppression (or cut off) of information in panics 168, 175, 176, 238 suspension of convertibility, see suspension of convertibility Clearinghouse loan certificates 22, 169, 239, 240, 249–250, 257 Clearinghouse loan committee, see clearinghouses Clews, Henry Coase, Ronald 157 235, 243 Collateral 7, 10, 32, 33, 34, 35, 172–173, 591, 598–601, 610–611 Index Commercial and industrial loans (C&I loans) 433–434, 477–479, 483 Commercial paper, see asset-backed commercial paper Confidence, see debt Contract, contracting 5, 13, 17, 25, 35, 44, 45, 46, 55–57, 58, 63, 65, 122–123, 147, 168, 184, 203, 209, 210, 235–237, 241, 243–245, 259, 260, 287, 319, 321, 324, 335, 606–607, 613 clearinghouse 246, 248 collateral and 321 compensation 474 differences between bank deposits and bank notes 245 implicit, relational 31, 508, 509–510, 524, 529–531, 533–534, 546, 556–557, 571 liquidation option and 319, 324, 325, 327, 339, 343, 344 loan sales 508, 509, 512, 523 noncontractible, contractible 7, 267, 281, 281 redemption option in 73, 124, 136, 150, 248 renegotiation and 281, 318, 321, 337–339, 350–351 secondary loan participations 505 suspension of convertibility, see suspension of convertibility underwriting 507 Control rights, see German universal banking Credit booms 34–35, 598, 600, 615, 617–618, 626, 640, 643, 645, 646, 647, 650, 654 Credit card loans 29, 32–33, 172, 410–412, 419, 421–422, 423, 426, 428, 430, 445, 528, 530, 531, 533, 539, 540–542, 544, 559, 560–561, 567–571, 585 A-Note spreads 562–565, 565–567 B-Note spreads 565–567 Credit crunch 27–29, 408 671 Cross share-holding, see German universal banking Currency premium 22, 169, 170, 177 Debt bank debt 654 common pool 650, 652, 653 confidence in 3, 23, 165, 175, 242, 243, 245, 252, 253, 256, 264, 266, 272, 598, 626, 649, 657 demand deposits, see demand deposits information-sensitive 606 information-insensitive 8, 598, 599, 600, 606, 607, 608, 609, 610, 614, 615, 656, 657 kinds of bank debt 651 vulnerability of bank debt 1–2, 155, 156, 171, 173, 176, 238, 283, 583, 595, 647, 648, 649, 651, 652 654, 658, 659 Debt forgiveness 279, 284–286, 290, 299 Demand deposits 15–17, 157, 162, 236, 243–245 capital losses 211 Deposit-currency ratio 202, 206, 208, 212, 216–219, 222, 227, 228, 229, 231 Deposit insurance 30, 46, 58–61, 227, 240, 583 state 79, 86, 123, 127 Depositors 191, 193, 203 confidence 243, 245, 252–253, 256 Diamond, Douglas 11, 70, 320 Diamond and Dybvig model 3, 7, 24, 25, 45, 197, 271, 278, 602, 648, 649, 654, 656, 657 Discount window 20, 174 Early amortization, see securitization Efficiency 12 n9 economic 12, 235, 256, 279, 292–293, 298, 299–300, 302, 317, 319, 325–328, 340, 343, 345, 622 market 16, 155, 159, 275, 278, 289–290 Egerton v Buckner 14 Excess spread, see securitization 672 Federal Savings and Loan Insurance Corporation 273 Federal Reserve System 20, 24, 27, 227, 235 Forbearance 273, 275–276, 295, 300, 302 Financial crisis business cycle, see business cycle concept of 639 dating 642 definition of 8, 598, 640–643 end of 653 exit from bank debt 639 information event 4, 17, 18, 19, 35, 36, 156, 171 lack of data 642–643 macroeconomic news or signal and 4, 8, 17, 18 stylized facts 643–647 theory 647–654 Financial Crisis Inquiry Commission (FCIC) 34, 597, 598 Financial crisis of 2007–2008 8, 15, 34, 36, 154, 171, 173, 583–584, 638, 651 Financial Institutions Development Fund 301 Financial intermediation 44, 45, 55, 62, 344, 505, 506, 525, 644 Financial Reconstruction Commission 301 Fondo Bancario de Proteccion al Ahorro (FOBAPROA) 301 Forbearance 273, 275–276, 295, 302 Free Banking Era 6, 9, 11, 13, 69–70, 72–73, 75, 122, 125, 157, 236, 584, 654 Friedman, Milton 8, 15, 122 German codetermination 356, 374–375, 388 German universal banking 26, 354–356 blockholding of stock 355 Cable’s (1985) study of 390–392 conflicts of interest 355, 372–373, 385–388 control of proxy votes 355 control rights 355, 357, 359–363 Index cross-shareholding 359 hidden reserves 355 illiquidity of bank blocks of shares 376–377 nonbank shareholders 373–374 proxy voting 364–365, 372–373 pyramids 358, 359, 360–361, 395, 397, 401–403 supervisory board 392–394 voting restrictions 355, 365–368 Government debt, or government bonds 61, 274, 295, 301 Great Depression 2, 3, 4, 20, 173, 203, 232, 256–257, 266, 275, 296 Green-Porter model (1984) 407, 409–410, 444, 533, 556 Grossman, Sanford 279 Hammond, Bray 15, 248 Herfindahl Index 364 Holmström, Bengt 7, 8, 9, 16, 25, 35, 36, 278, 598, 656, 657 Implicit recourse, see securitization Information-insensitive/informationsensitive debt, see debt Kiyotaki-Moore (1997) 602, 657, 658 “Large” shocks 597, 602, 626, 657, 658 Lemons market 44, 57, 70, 72, 74, 83, 92, 93, 506, 546 Lender-of-last-resort 157, 171, 255, 261, 265, 269, 272 Liabilities of failed nonfinancial businesses 19, 196, 213, 215, 221, 222, 224, 225, 227, 228, 231, 232 Liquidity 5, 24, 45, 275–278 adverse selection and bank debt 654 consumption insurance creation 55, 58, 61 definition 7, 302 discount 288–289, 291–292 government provision of 293–295 pledgeable cash flows traders 47, 50–51 Index Liquidation 287–290, 298 Loans, see bank loans Loan renegotiation, see bank loans Loan sales 30–31, 504–510 data 516–520 Locally weighted regression (LOESS) 381, 498–500 Lucas, Robert 111, 140, 208 M-statistic 381–383 Managerial entrenchment 30, 470 Maturity transformation 649 Medium of exchange 44, 74, 75, 81, 82, 110, 125, 146, 147, 272 Minsky moment 603 Mitchell, Wesley 19, 206 Modigliani-Miller theorem Moral hazard 256, 259–260, 281–284, 286, 287, 291–292, 297–298, 299, 327, 485 due to deposit insurance 29–30, 459, 460, 462, 475, 490–491, 584 in loan contracting 25, 318, 346 in loan sales 508–510 two-sided 25, 26, 327 Mortgage-backed securities (MBS) 35, 172, 598, 599, 601, 626 National Banking Era 1, 2, 4, 18, 19, 166, 170, 197, 201, 202, 203, 206, 213, 216, 224, 227, 229, 231, 643, 644, 646, 653 New York Clearing House 21, 170, 247, 252 Newfang, Oscar 2, 3, 24 Noise traders or uninformed traders 6, 14, 43, 46, 277 Opacity of banks 16, 17, 21, 27, 28, 154–156, 166, 173, 176, 177, 599, 600, 626 Panic of 1837 3, 17, 133, 581, 583 of 1839 96, 127 of 1857 133, 239, 249, 583, 651 of 1866 651 of 1873 170, 260, 583 673 of 1884 221 of 1893 4, 240, 583 of 1907 2, 36, 240, 581, 582, 583 of 1914 239 2007, see financial crisis of 2007–2008 Penn Square Bank 504–506, 508 Performance Difference Index (PDI) 410–411, 434–436 asset pricing 437–444 for commercial and industrial loans 431–432 Pierson v Wallace 14 Pig iron production 209–211 Private bank note, see bank note Private benefits of control 30, 371, 372, 374, 395–396, 460, 462–470, 491–495 Proxy voting, see German universal banking Pyramiding, see German universal banking Railroads 134, 296 Reconstruction Finance Corporation 275, 301 Renegotiation of bank loans, see bank loans Repo 17, 32–34, 171–172, 583, 590–593, 600, 651–652 Reputation acquisition 11, 31–32, 69–70, 91–93, 107 Resolution Trust Corporation 275 Rockoff, Hugh 10, 78, 123 Rolnick, Art 10, 78, 123 Roosevelt, Franklin 3, 4, 24 Sale and repurchase agreements, see repo Savings and loan crisis 3, 274, 648 Savings and loan associations, see thrifts Securitization 31, 33–34, 528, 540, 586–587 bankruptcy remote 532 credit cards, see credit card loans credit enhancement 539–540, 544 excess spread 543–544 early amortization 543–544 implicit recourse 531, 544, 555–558, 560–561 674 safe debt 34 Securitization (Cont.) seller’s interest 543 Senior Loan Officer Opinion Survey of Bank Lending Practices 408, 432 Shadow banking 17, 33, 34, 154, 166, 171, 172, 173, 292, 586–589, 595, 641, 651 Shapley-Shubik Power Index 364 Short sales of bank stocks 174–176 Smith v Goddard 14 Special purpose vehicles (SPVs) 31–32, 528–534 accounting 534–536 bankruptcy remoteness 532, 536–537 legal form 534 qualified off-balance sheet 539 subprime, see subprime securitization taxes 537–539 trusts, master trusts 542–543 Speckman (1988) 482, 498 State insurance funds 79, 86, 95, 123, 127 Stigma 20, 173–174, 178 Stock market 26, 45, 46, 48–55, 150, 156–157, 355, 360, 370, 373, 376, 394–397 bank stocks 164–166 banning short sales, see short sales of bank stocks closing 16 crashes 3, 227 Germany and 357 Stress tests (SCAP) 174–175, 178 Index Subprime mortgage-backed securities 155, 585–586, 592, 595, 597, 600–601, 626 Suffolk Bank 129, 134, 146, 148, 257 central bank-like 79, 95–97, 127 Sunspots 205, 602, 649–650 Suspension of convertibility 17, 18, 22, 183–184, 194–199, 211, 251, 271 Tail risk 598 Technological change 12, 71, 73, 75, 104, 106, 107–109, 124, 139, 147, 150, 158, 459, 465 Telegraph 71, 73, 75, 104–107 Tequila crisis 301 Term Auction Facility 23, 174 Thrifts 273–274, 462 Tirole, Jean 7, 278 Too-big-to-fail 23, 521 Transparency 154–155, 171, 176, 599 Transportation costs 76, 124, 136, 146, 158 Travelers’ guides 12, 73, 106, 125, 136 Troubled Asset Relief Program (TARP) 174 Van Court’s Counterfeit Detector and Bank Note List 77, 79, 128–129, 145, 158 Voting restrictions, see German universal banking Weber, Warren 10, 78, 123 Wildcat banks 10, 11, 13, 69, 70, 71, 73, 78, 83, 97, 110, 117, 123, 146, 147, 150 ... The Maze of Banking The Maze of Banking History, Theory, Crisis GARY B GORTON Oxford University Press is a department of the University of Oxford It furthers the University’s objective of. .. period between the U.S Civil War and the founding of the Federal Reserve System Until the financial crisis of 2007–2008, there had not been a financial crisis in the United States since the Great... a member of the Monetary Commission and ex-Secretary of the Treasury put it, speaking of the U.S Panic of 1893: The thing that impressed me was the entire disappearance of all forms of money