First-come first-served

Swarms of people lining up, sweaty faces, sunburned necks, impatience, frenzy. What makes people stand in line for hours and hours?

“The dream of an iPhone!” you offer, still fresh from your triumphant struggle through the hordes of gadget freaks lined up outside the Apple store the day the new iPhone was released.

Possibly. Yet, that very same day another line was forming in Pasadena, California, this time outside mortgage lender Indymac. The bank was forced to close down after panicked depositors rushed to withdraw their savings upon concerns it was about to fail. A “bank run” traditional style and of 19-billion-dollar proportions.

So are bank runs any different from iPhone “runs”? And… can they spread?

Anatomy of a bank run: Any bank is in principle vulnerable to a run by virtue of the very service it’s supposed to provide: Borrow money from its depositors and lend it to productive sectors of the economy, like oil rigs, wind mills or real estate.

In the process, the bank exposes itself to liquidity risk: Businesses repay their loans only in the long run, since the payoffs from their investments take long periods to materialize. This means that a bank’s available cash is usually limited, since most of its assets are (illiquid) long-term loans. Depositors however could ask to withdraw cash at any moment, depending on their individual spending needs.

The reason banks survive is that, normally, not all depositors have similar spending needs at the same time—Apple doesn’t launch a new iPhone every day! But what if you learnt that, for whatever reason, your bank was suddenly experiencing heavy deposit withdrawals?

At first you might nod with skepticism—this is your trustworthy local bank after all! But then, being the rational human being that you are, you start thinking: What if others react to the news by taking their money out? Your bank has only few liquid assets so it’s going to be a first-come first-served situation. The longer you wait, the more you risk being left out. So you run. And so does everyone else and your bank goes bust, regardless of its true worth.

With shoes worn out, your money in your pocket and your bank bust… what about the other banks? Could your run be contagious?

Herds counting sunspots: Economists differ as to how a crisis could spread. One school of thought blames contagion on… sunspots . Meaning factors that (like sunspots) have nothing to do with the health of the banking system. The term “sunspot” itself is a bit of a joke, inspired by the attempts of a 19th century economist to relate the number of spots on the sun’s surface with business cycles on earth. Some took him seriously enough to conduct further studies that, unfortunately, refuted his results. Subsequently economists have been using the word to signify a factor that is completely extraneous to the system under study.

What would a sunspot-driven crisis look like? Let’s see. Your bank goes bust, Martians send instant iPhone alerts, CNN arrives, drama on TV screens, close-up on a hapless old lady who can’t run fast enough and loses her lifetime savings. YouTube replays. Bloggers corroborate with chilling tales of “financial hostages” battling for survival. Suddenly, everyone expects everyone else to withdraw their deposits, regardless of their banks’ intrinsic health. Herd mentality hits, “run” becomes the word—on every bank, indiscriminately…

…A suboptimal outcome no doubt. Indeed, it’s galling to think that, if most banks are healthy, a better state of the world would have been perfectly viable: One with no panic, no widespread run and efficient capital allocation. Instead we fall into misery because of extraneous “sunspots,” naughty Martians and the like. This means there is an unambiguous case for government intervention (e.g. in the form of deposit insurance) to prevent the bad equilibrium from happening.

The guessing game: Another school of thought argues that a banking crisis can spread because some banks are fundamentally weak and not all depositors know exactly which banks are and which ones aren’t.

So say your neighbor sees you running to withdraw your deposits. You’ve always impressed her as an “informed” kind of guy, iPhone and all, so she, the “uninformed,” infers that something is fishy. Your bank must be in trouble so maybe hers too—both had been lending aggressively to riskier mortgage borrowers in recent years. On top of that, every bit of news hitting the wires is about collapsing home prices, foreclosures, personal bankruptcies and so on. Can’t be good for banks! So as soon as you start running on our bank, she runs on hers and the entire neighborhood follows.

This time the run is not indiscriminate. It’s not because, suddenly, everyone expects everyone else to run on every bank, no matter what. Instead, the “news” of you running signals trouble at your bank and makes others reassess the quality of their own. With information insufficient at best, banks with similar risk characteristics to yours—like rising non-performing loans, large investments in low-quality mortgage securities or low capital—become obvious run-targets.

Notice that here the case for government intervention is not as unambiguous as before. If it’s troubled banks that are forced to fail, failure can lead to a better state of the world—one where banks learn to “behave,” risk is efficiently shared and capital allocated prudently. Still, even here there may arguments for the government to step in: For example, if the panic forced troubled banks into “fire sales” of their assets, the ensuing collapse in broader asset prices could hit healthier banks.

Early warnings: So with a multibillion dollar bank failure (and a few smaller ones) already underway, what’s the risk of a broader contagion today?

When it comes to the risk of pure (“sunspot”) contagion, this is arguably diminished. True, Apple has shown that herd mentality is very much alive. And yes, we still have CNN, YouTube and a few Martians. But we also have deposit insurance. Provided FDIC’s funds remain ample and its execution malfunctions are addressed, the risks of a major shock to public confidence are small. (Though it beats me how FDIC failed to put Indymac on its list of “problem banks” as recently as last March!)

More likely would be a scenario of runs spreading due to fears there are many Indymacs out there, with large exposures to the ailing housing sector and ill-judged investments in risky mortgage securities. In fact, Indymac is a stark reminder of the scale of potential losses lingering in the system: FDIC’s estimate that it will need to pay between $4 and $8 billion from its own coffers to cover the $18 billion of insured deposits suggests that the fair value of Indymac’s assets (many of those in Alt-A mortgage securities) is around $10-$14 billion, compared to the $30 billion reported in its books! Who else holds Alt-A’s or any other junk?

Clearly, timely and credible information is key for preventing panics and an unnecessary, system-wide crisis. At the same time, it’s also unrealistic to expect people to take pains to gather detailed information about the riskiness of their banks. In which case, I long for the day Apple launches an “early warning” service with instant iPhone alerts about my bank’s Tier 1 capital and non-performing loans. In fact, I’ll run for that!

Originally published at Models & Agents and reproduced here with the author’s permission.