Lecture 9. The Emergence of Financial Crises
Recommended reading : 【Economic History】 Economic History Table of Contents
1. Monetary system
2. Banking system
3. Bank run
4. Central banking system
1. (Reference) Monetary system
⑴ Definition of money
① A generally accepted medium
② (Reference) A German scholar named Hahn (Hana?) argued for the state theory of money
○ A theory that something becomes money because the state defines it as money
○ Doesn’t fully fit (e.g., the Korean won vs. the U.S. dollar)
③ Conditions for money : Goods that spoil easily are unlikely to become money
⑵ Money emerges spontaneously
① Money is superior to barter in that it makes a “coincidence of wants” possible
② Money increases the volume of exchange itself
⑶ In antiquity, good money encouraged bad money
① Only one uniquely “good” bank issued banknotes
② As banking emerged, lenders of last resort also emerged spontaneously
⑷ Gresham’s law : In modern times, bad money drives out good (bad money drives out good)
2. (Reference) Banking system
⑴ Roles of banks
① Type 1. Lending banking (fractional-reserve banking) : Earns profits by using the deposit margin for lending and investment
○ Continuously screens and monitors borrowers to recover loans
○ Nowadays, banks also earn profits by using portfolios of debt securities and marketable securities, not only “capital–deposit–loan” activities
○ It is not an exaggeration to say banks do business through credit : Creating credit means creating money
○ The gold standard provided an early banking system with a means to create credit
② Type 2. Deposit banking : 100% reserve banking (100 percent reserve banking)
○ Safekeeping money from various risks and charging depositors a usage fee
③ Banks contribute to economic growth : because they increase the efficiency of resource allocation
⑵ Development of banking
① Alexander explains that differences in countries’ initial banking conditions later determined whether they became financial powers
② The first banknotes were issued by Stockholm Banco, a Swedish bank led by the Dutch banker Johan Palmstruch○ Stockholm Banco was a deposit bank that borrowed money from the public
○ Both loans and deposit receipts were issued in the form of banknotes
○ Banknotes became standardized like modern paper checks, and were preferred over the heavy copper plates then used as a means of payment in Sweden
○ Its short history (1657–68) ended with a bank run
③ Banking in the United Kingdom : commercial banking
④ Banking in Germany : universal banking (combining commercial and investment banking)○ Unlike the U.K., it can attract long-term investment : very important for Germany’s catch-up
○ Critique 1. This logic has not been empirically demonstrated
○ Critique 2. Although the U.K. trades short-term, it is rolled over routinely, so it may be less short-term than it seems
⑤ Banking in France : universal banking like Germany (as in the notes)
⑶ (Related concept) Usury / moneylending
⑷ (Related concept) Stock market
① Difference 1. Who collects information
② Difference 2. Types of assets handled
③ Banks
○ Basically perform information acquisition, information distribution, and crisis response
○ By valuing non-securitized assets, they lend to industries with lower risk and higher returns
○ In the late 19th century, there were relatively few marketable assets, while a very large share of assets were non-marketable
○ By the 1950s, almost every household had a bank account
○ In contrast, only about 10% had a stock account
④ Stock markets
○ Basically perform information acquisition, information distribution, and crisis response
○ The public supplies funds for a tiny subset of securitized assets
○ Efficient Market Hypothesis : Using information in the market, can you earn returns higher than the market return? The hypothesis says no○ Hence, the stock market is “efficient” in that sense
○ But that does not mean the prices formed in the stock market are rational
⑤ Why both banks and stock markets exist
○ Even if a bank collects accurate information about a firm, it may not offer a reasonable interest rate
○ So the stock market can be an alternative
⑥ Banking reached a sophisticated level of development earlier than stock markets
⑦ An economy in which firms do not rely entirely on banks, nor entirely on stock markets, may be the best solution
⑸ (Related concept) Foreign exchange market
① A reason one can systematically make money in FX markets is that there exists an entity that intervenes systematically
3. Bank run (bank-run)
⑴ (Reference) Bank failure
① Insolvency crisis : when a bank’s liabilities exceed its assets
② Liquidity crisis : when assets are temporarily tied up (e.g., long-term loans) so the bank cannot meet depositors’ demand for funds
⑵ Bank runs occur as self-fulfilling prophecies
① 1st. A bank takes deposits and promises depositors the right to withdraw at a positive interest rate and a fixed nominal value
② 2nd. The bank provides borrowers loans at a fixed nominal value, but evaluating future value is difficult, so it sometimes miscalculates
③ 3rd. Borrowers cannot repay, and depositors rush to withdraw out of fear that they will not be able to retrieve their deposits○ If depositors begin withdrawing because they think a bank run will occur, a bank run occurs (self-fulfilling)
○ Depositors usually do not know what bankers do inside the bank, and they tend to be loss-averse, so they have an incentive to withdraw as quickly as possible
④ 4th. The bank faces liquidity constraints; without a central bank as lender of last resort, it fails
⑤ When there is no central bank, a bank run is also a way for depositors to “punish” a bank
⑥ The early history of banking is a history of frequent failures○ Banks tended to hold too small a portion of deposits as reserves
⑶ Preventive measure 1. Deposit insurance
① A system that prevents bank runs by having an insurance corporation pay depositors (up to a limit) even if a bank fails
○ Restores the public’s willingness to save at banks
○ Domestic saving positively affects domestic investment, so it may also have growth-promoting effects
○ From the public’s perspective, adopting deposit insurance after the Great Depression was beneficial
○ In Korea, deposit insurance applies up to 50 million KRW
② Limit 1. By making supervision and capital monitoring looser, it can make banks more adventurous and less careful
○ There is evidence of this
③ Limit 2. Non-deposit institutions can also trigger bank runs
○ Nowadays, beyond lending/investing via deposit margins, portfolios in debt securities and marketable securities are also substantial
○ Close relationships between non-deposit financial institutions and banks have become prominent
○ Example : (as written in the notes) Bank of America failed because a non-deposit institution caused a bank run
⑷ Preventive measure 2. Relationship banking : Sending one banker to serve on each firm’s board (mainly Germany)
① The bank learns internal information about the company
② Benefit to the bank : Less risk of lending to an unsound firm
③ Benefit to the firm : Even if a sound firm temporarily faces a liquidity crisis, it is not difficult to obtain funding from the bank
⑸ Preventive measure 3. Bank holiday : Temporarily suspending bank operations (about 7 days) to restrain withdrawals and prevent bank runs
⑹ No institutional innovation can eradicate financial crises
① The fate of fractional-reserve banking, which holds only part of deposits as reserves and lends out the rest
○ Reason : Banks invest today’s value into future value, so there is uncertainty
② What an individual financial institution calls “innovation” often tends to increase systemic financial-crisis risk while capturing private profits
○ Therefore, finance should be regulated appropriately
○ Looking at history, there were many financial bubbles, and bubbles ultimately burst
4. Central banking system
⑴ (Reference) The era of free banking (free banking society) : a period with no central bank
⑵ Most central banks formed in the late 19th century were modifications of private banks such as the Bank of England or the Banque de France
⑶ Function 1. Lender of last resort
① Historically, central banks did not perform the lender-of-last-resort role well
② This is related to “too big to fail” bailout finance discussed below
⑷ Function 2. Bank supervision
① 1st. For some time after their emergence, central banks supervised multiple banks
② 2nd. At first, they thought each country would have at most 5–6 banks maintaining an oligopolistic market
③ 3rd. After World War II, when banks merged into larger units, most became “too big to fail”
④ 4th. If a too-big-to-fail bank fails, the national economy can be shaken
⑤ 5th. Too-big-to-fail bailout finance : The central bank, acting as lender of last resort, rescues a too-big-to-fail bank before it fails○ Then such bailouts began to operate not only for liquidity crises but also for too-big-to-fail banks that were insolvent
⑥ 6th. Bankers pursue “high risk, high yield” and try to push business forward while taking excessive risk
○ Reason : If successful, investors earn higher profits and bankers receive larger bonuses
⑸ Function 3. Banknote issuance
① Under the gold standard, “hard money” was limited by the quantity of gold coins, so a banking system capable of creating credit was important
② After the gold standard was abolished, the central bank’s money-issuing power became even more important
Entered: 2020.07.11 10:45