The brain is an interesting organ which can make life either pleasant or unbearable depending on how it is used. Despite the fact that most of us try to harness this organ in order to live life as wholesomely as possible, scientists are still not sure regarding just how it works.
One common way to verify the ideas proposed in cognitive psychology would be to study patients with brain damage. In cognitive neuro-psychology, theorists study subjects with lesions and see what is not working properly when compared to normal individuals. If a certain part of the brain is damaged and yields very specific deficits, theories can be shaped to account for that deficit.
In a similar manner, economists and finance professionals can learn more about sustainable, well-functioning economies by understanding in more detail economic phenomenon like bank runs.
Minor Backtrack
Previously on the blog in the article, Incidents from Japan and Britain, we analyzed a variety of banks runs caused by very different situations. As helpful as that article was on building an understanding on this phenomenon, it failed in providing categories to aid in classifying the different types of bank runs.
Just as there are different types of lesions which aid cognitive neuro-psychologists to better understand how different parts of the brain aid in activities such as speaking and listening, there are different types of bank runs which can help us understand how the banking system works beyond the surface level.
To continue the excerpt based writing theme introduced not so long ago on the blog, we will make use of one George Kaufman’s article on bank runs in order to improve our knowledge on this phenomenon. The excerpt goes as follows:
“Of course, if the depositors’ fears are justified and the bank is economically insolvent, other banks will be unlikely to throw good money after bad by recycling their funds to the insolvent bank. As a result, the bank cannot replenish its liquidity and will be forced into default. But the run would not have caused the insolvency; rather, the recognition of the existing insolvency caused the run.
A more serious potential problem is spillover to other banks. The likelihood of this happening depends on what the “running” depositors do with their funds. They have three choices:
1- They can redeposit the money in banks that they think are safe, known as direct redeposit.
2- If they perceive no bank to be safe, they can buy treasury securities in a “flight to quality.” But what do the sellers of the securities do? If they deposit the proceeds in banks they believe are safe, as is likely, this is an indirect redeposit.
3- If neither the depositors nor the sellers of the treasury securities believe that any bank is safe, they hold the funds as currency outside the banking system. A run on individual banks would then be transformed into a run on the banking system as a whole.
If the run is either type 1 or type 2, no great harm is done. The deposits and reserves are reshuffled among the banks, possibly including overseas banks, but do not leave the banking system. Temporary loan disruptions may occur because borrowers have to transfer from deposit-losing to deposit-gaining banks, and interest rates and exchange rates (see foreign exchange) may change. But these costs are not the calamities that people often associate with bank runs.
Higher costs could occur in a type 3 run, because currency (an important component of bank reserves) would be removed from the banking system. Banks operate on a fractional reserve basis, which means that they hold only a fraction of their deposits as reserves. When people try to convert their deposits into currency, the money supply shrinks, dampening economic activity in other sectors. In addition, almost all banks would sell assets to replenish their liquidity, but few banks would be buying. Losses would be large, and the number of bank failures would increase.
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Harnessing the Information Provided
One application from understanding the different types of bank runs would be designing financial safeguards that better limit the impact of a run on banking institutions. It is important to note that we mention financial safeguards and not financial products.
Financial products like derivatives can ,as they have been previously, be misused to the detriment of an economic system. I advocate for a regulatory environment that will better manage the peaks and troughs of the economy more sustainably, as is the case currently in several countries.
In so doing, one would reduce the probability of bank runs occurring. Legislation that serves as a good guide to achieving this would follow a structure outlined by the Dodd-Frank Act. Another interesting tool that can aid policymakers and economists to protect banks would be network analysis. This will be explored in more detail in subsequent articles. Complement this article with the following video.
References
Cognitive Theories and Brain Damage, BrainBlogger.com
What do we learn from studying traumatic brain injury, frontiersin.org
Dodd-Frank Wall Street Reform and Consumer Protection Act, Investopedia.com
Bank Runs, econlib.org
Incidents from Japan and Britain: Understanding Bank Runs, iridiscentcapitalprojects.com
The role of derivatives in creating the mortgage crisis, thebalance.com
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