How to Expand an Asymmetric Information Crisis

Yesterday the Financial Times reported that state of California, facing a budget deficit of more than $24bn, started issuing IOUs to continue spending for state services. The state will pay, “…businesses, students receiving financial aid, taxpayers expecting refunds, and local governments,” in the IOUs, said John Chiang, the state controller. The Governor of California, Arnold Schwarzenegger has reportedly spoken with the heads of several banks. So far, Bank of America and Wells Fargo have confirmed they will accept the IOUs.

While Schwarzenegger maintained that California has never defaulted on its debts, it was home to one of the largest ever municipal bond defaults, that of Orange County. State default can occur, nonetheless: Indiana, Florida, Mississippi, Arkansas, Michigan, Illinois, Maryland, Pennsylvania, Louisiana all defaulted in the 1830s and 1840s, and by 1965 there had been some 22 events in which states defaulted on their debt.

But default is not necessary for an asymmetric information financial crisis. The only necessary ingredients are a shock to asset values and a lack of information about the incidence of holdings. Without knowing who is holding the assets, investors rationally divest all possible suspects en masse until better information becomes available.

How do state IOUs relate to asymmetric information crises? Well, in 1932 the City of Chicago had been issuing similar IOUs – called tax anticipation warrants – to city employees, students, and creditors. By spring 1932 the IOUs had began to circulate as an alternative to cash in the Chicago region, from Milwaukee to Michigan. But as Chicago’s fiscal condition continued to deteriorate, questions began to be raised about the viability of the City and the value of the IOUs.

Pressures began to build among local and regional banks as those IOUs began to accumulate. The banks began to seek rediscount authority at the Federal Reserve. The city sought aid from the Federal government. A delegation of Chicago city officials and bankers visited Congress to request federal governmentassistance for the city in June 1932. The delegation’s request for $80 million in aid was rebuffed by Congress on June 22 (Chicago Tribune, June 23,p.1). According to Calomiris and Mason (American Economic Review, 1997), “…By June 23, Chicago bank depositors had witnessed, in a matter of only two weeks, the collapse of some of the largest businesses in their city, several enormously costly cases of bank fraud, and a deepening of the municipal financial crisis as the result of the denial of relief to their city government by federal authorities. All of these stories were front page news day after day in the two weeks leading up to the banking crisis, and the news grew progressively worse.”

The Chicago Bank Panic of June 1932 began upon the delegation’s return from Washington and the public announcement of Congress’ decision on the train platform. Lines formed at every bank in Chicago, including the largest and most powerful institutions in the Loop. The scene was right out of “It’s a Wonderful Life,” complete with the President of First Chicago hollering from a pillar in the lobby that the Fed is sending over plenty of cash and there was no need to worry, while cashiers paid out depositors in the smallest denominations possible in order to buy time.

According to Calomiris and Mason the Chicago Panic was the largest and most important bank panic of the Great Depression. “With the exception of the June panic, no contemporary chronicler or scholar of which we are aware has identified any other time interval during 1932 as a panic or banking crisis in Chicago. Neither has anyone identified any nationwide banking panics as having occurred during 1932.” Moreover, bank asset quality played a key role in such a massive disruption. “…[A] variety of facts that identify the Chicago bank panic of June 1932 as a quintessential example of an asymmetric-information-induced panic, resulting from local economic problems that affected bank asset values.” (AER 1997)

We have already experienced a modern-day bank run in this crisis, where modern day bank funding (investors in securitizations rather than uninsured depositors) evaporated overnight as a result of an unknown incidence of poor asset quality. Allowing banks – chief among them Bank of America and Wells Fargo – to accept new forms of questionably-valued assets is therefore probably not prudent at the present time. Even if, as rumored today, those large banks refuse to accept the IOUS, smaller bank concentrations can still cause problems. At the very least, regulators should be thinking of how to track these IOU concentrations and place limits on undue accumulations. Alternatively, the Federal Reserve should be thinking about how similar state IOUs fit into their asset repurchase programs in preparation for the next possible stage of the crisis.

† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC.

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Copyright Joseph R. Mason, 2009. All rights reserved.

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