Saturday, September 24, 2011

On "Cascading Default, Bank Runs and Catastrophic Risk"

When the depositors in a bank all want their money at once--due to a panic for example--no bank in the world can survive. The New Deal ushered in FDIC deposit insurance in 1934 to address this reality, by putting the full faith and credit of the US government behind every bank in the US. Legal infrastructure thereby vanquished bank runs. The rest of the developed world followed suit and the prospect of a bank run destabilizing global financial institutions leading to a general economic collapse faded from memory.

Well, this weekend we should all review the experience of Credit Anstalt in 1931. Today, Treasury Secretary Timothy Geithner speaking at the world conclave of financial leaders this weekend in Washington DC said this: "The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts, both within Europe and globally." As recently as ten days ago Geithner said there was "no chance" of a European Lehman moment. Now its on the table, he's talking about it, and he apparently cannot get Eurozone leaders to resolve it without a public scolding that actually enhances the risk he fears. Instead of taking the risk off the table, the Eurozone now seeks to contain the contagion of Greek default. They are playing with fire. That is the scary reality of this weekend.

This past week saw downgrades a-go-go: Moody's downgraded 8 Greek Banks due to their holdings of Greek Debt, including the four largest; S&P downgraded seven major Italian banks shortly after downgrading all of Italy's sovereign debt; Moody's downgraded Bank of America, Wells Fargo, and Citigroup; and, Fitch found Greece "likely to default." Meanwhile, Siemens, China and Lloyd's of London are all cutting their exposure to the Eurozone and pulling out their cash. Reports out of Europe now claim that authorities in Athens and the EU are planning for a Greek default.

So that begs the question: Can the system withstand a managed Greek default? I am very skeptical, for two reasons: human psychology suggests a large possibility for sheer panic; and, deposit insurance will not operate to protect banks from runs. Sovereigns no longer have the ability to back their largest banks--they are now too often too big to save. Deposit insurance only protects retail depositors. The world's megabanks need access to funding far beyond mere depositor funds. Also, the contagion has already cut off funding access to even the largest Italian banks. At this point in time only shock and awe will work. Will the German people pay trillions to bailout Spanish and French banks as well as the sovereign debt of Portugal and Spain and Italy? Will voters in the US and UK go along with more money for the IMF?

The news this weekend (in the European press) is that after months of denial, Greece will default, the Eurozone is insolvent if it does, and it will now take trillions to save European Banks and bailout Spain and Italy and Portugal. Oh, and by the way we need at least 17 national parliaments to approve this nightmare.

I see unlimited downside after this weekend.


  1. I agree that the potential for unlimited downside exists. However, there is always the remote possibility that the world economy suddenly begins to rebound thereby at least partially curing itself. Assuming this does not occur, I believe the psychological impact of a Greek default is very real and perhaps even more damaging than the actual harm caused. It would immediately decrease the wealth of those invested in the stock market. Unemployment would also rise as businesses would likely cut their labor forces to maintain profits. Even fewer homes would sell and they would sell for less on average. Maybe this is taking it a bit far; however, this snowball effect could very well be a reality if Greece were to default and it were not sufficiently contained. It appears as though it might be past the point of containing.

  2. Though not a solution to the problem raised by the author (managed Greek default), perhaps more incentives for maintaining deposits with banks might be considered as part of an overall attempt at fixing the problem of bank runs? If an investor wishes to purchase a CD, early withdrawals come with a penalty. Is there some way to give the average investor an incentive for maintaining funds with depositors when not needed so as to reduce damage caused by bank runs?