From: Foundation for Economic Growth

Confidence Trick
By The Economist
Sep 27, 2007, 18:35

“MOST bankers dwell in marble halls/Which they get to dwell in because they encourage deposits and discourage withdrawals.” Ogden Nash, the poet, captured the essence of banking, but how does one discourage withdrawals; in other words, avoid a run on the bank? As the turmoil at Northern Rock, a British bank, has shown, panic among depositors can lead to panic measures: in effect, the British government was rumbled into guaranteeing the deposits of any bank that suffers during this crisis.

The problem has dogged the financial system throughout history, for the simple reason that no bank can survive if enough of its depositors want to be repaid at the same time. Sometimes, subterfuge has been the only answer. In his classic study, “Manias, Panics and Crashes”, Charles Kindleberger recounts how the Bank of England averted a run on its own finances in 1720. The bank managed to get its friends to the front of the queue and arranged for them to be paid, very slowly, in sixpences (then worth a fortieth of a pound). The friends then came back through another door to deposit the coins, which had to be laboriously counted again. This delayed the ability of other depositors to withdraw money until confidence was restored.

Another device is to close the bank altogether in the hope that depositors will change their minds in the meantime. Although a “bank holiday” in Britain is now seen as a chance to take the family to the seaside, it was once a device for calming markets. It seems unlikely, however, that steam-age delaying tactics would work in the era of 24-hour news coverage and internet banking.

An alternative is to organise a bail-out of the beleaguered bank, by urging other banks to chip in or buy it. In Britain many a small building society (a mutually owned mortgage bank) has been persuaded over the years to absorb one of its smaller competitors. As the rescues of IKB and SachsenLB showed last month, the German authorities can still pull this off.

Whether it is still possible in the Anglo-Saxon world is another matter. When the hedge fund Long-Term Capital Management wobbled in 1998, Bear Stearns, an American investment bank, refused to join in the rescue (hence the Schadenfreude at its recent travails). Global banks are less amenable to pressure from a single central bank. In addition, executives are answerable to shareholders who may question the merits of a rescue.

In the absence of a buyer, it is then up to the central bank to provide cash by acting as a “lender of last resort”. The Federal Reserve was created, in part, because of the banking panic of 1907 and unease that the crisis was solved only through the intervention of a private financier, J. Pierpont Morgan. As J.K. Galbraith remarked, the early Fed did not exactly excel at its task: “In the twenty years before the founding [of the Fed], there were 1,748 bank suspensions, in the 20 years after it ended the anarchy of unstable private banking, there were 15,502.” Milton Friedman argued that the failure of the Fed to protect the banks from failure in the aftermath of the Wall Street crash of 1929 led to a shrinkage of the money supply and prompted the Great Depression. Central banks have since taken that lesson to heart.

The tricky part lies in distinguishing between the times when a bank has run into trouble because of poor management and those where there is a general panic. When it is the bank's fault, the purist would not rescue it at all, so as to teach investors a lesson. In an essay entitled “State Tampering with Money and Banks”, Herbert Spencer, a British philosopher, said that “the ultimate result of shielding man from the effects of folly is to people the world with fools.”

The Bank of England seemed to be heading down this path in early September, when its governor, Mervyn King, warned against “ex post insurance for risky behaviour”. The problem, as Kindleberger explains, is that “history offers a number of occasions when the authorities were resolved not to intervene but found themselves reluctantly forced to do so.” Northern Rock is just the latest example.

Unfortunately, depositors also find it difficult to tell between the problems of an individual bank and those of the system as a whole. Hence, in a version of Gresham's law, bad banks drive out good ones. When that happens, politicians cannot withstand the backlash from angry depositors and central bankers fear the economic effects of a credit crunch.

It thus becomes difficult for central banks to follow Walter Bagehot's famous advice in his book, “Lombard Street”, about lending money only at a penalty rate against good collateral. Indeed, Bagehot himself said that, in a general crisis: “the only safe plan for the Bank is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent. This policy may not save the Bank; but if it do not, nothing will save it.”

Another consequence of the Depression was the creation of deposit insurance; by offering at least a partial guarantee for savers, the idea was to avoid the panic that led to a bank run in the first place. The fate of Northern Rock indicates that the British version does not do the job, because savers are unwilling to accept any loss and fear the bureaucratic delay in getting back their money. Hence the sudden guarantee for any struggling bank.

A big con, nonetheless.

However, this offer is only as good as the credit of the guarantor. John Calverley notes in his book “Bubbles and How to Survive Them” that guarantees from the governments of Indonesia and Argentina over the past decade were simply not believed. A moment's reflection suggests that the British government could not really guarantee £1.3 trillion of consumer deposits either. But, just like the sixpences, the assurance has, for the moment, done the (confidence) trick.

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