Term Paper on Money and Banking
The modern day economic growth and development depend on the existence of effective and proper functioning financial system. Indeed, the financial system is often referred to as the engine that drives economic growth and development. Through the financial system, surplus funds (savings) are transferred to deficit units (borrowers). The transfer of funds from savers to borrowers through the financial system is an important function in the economy as it facilitates borrowers to undertake numerous projects leading to investment, output production and economic employment. These functions are very crucial for economic development in a country (Nel, 2003). Therefore, the importance of a financial system alongside the elements associated with it towards economic growth and development cannot be overemphasized.
Within the financial system, banks play the most crucial role. Indeed, the significance of the banks originates from their ability to create credit and also the role of accepting liquid deposits and creating illiquid loans needed by borrowers. Converting liquid deposits into illiquid loans is known as asset transformation which enhances welfare by allowing entrepreneurs to access funds needed for investment. On the other hand, the banks maintain the liquidity of depositors’ on the basis of demand and term deposits (Gordon & Pennacchi, 1990). The fact that banks’ assets (loans) are illiquid in nature and are financed by liquid liabilities in the form of deposits is a major threat to the stability on banks which are exposed to runs by unable to assess the financial health of the banks accurately.
Runs on banks often originate from the existence of information asymmetry between banks and depositors. Such runs are often driven by rumours and can have very detrimental effects on banks. In most cases, they can lead to sudden collapse of a bank. When there are information asymmetries among depositors on the quality of the banks’ assets, panic and anxiety often ensues. Consequently, depositors may end up losing confidence in the banks viewing them illiquid. Panic among depositors often encourages massive withdrawal of deposits which could be limited to one specific bank or several banks through contagion effects. Manifold bank failures can have very devastating consequences on the financial systems and the economy at large as they present inherent systemic risk to the financial system (Hoggarth & Saporta, 2001).
Serious policy challenges are often associated with the consequences of failures in the banking and financial system. The challenges do not only have very dire effects on a country’s economy but also the global economy as a whole. Almost all countries have been afflicted by bank failures irrespective of whether they are developed or developing. Unfortunately, the trend is envisaged to continue into the foreseeable future. Numerous financial crises arising as a result of bank failures have been documented (Hoggarth & Saporta, 2001). The absence of explicit and well-defined scheme for protecting depositors has been associated with extensive panic and anxiety in the wake of rumours on bank failure. In view of the serious implications associated with uncertainty, deposits-bank panics and moral hazards, banks need to develop effective and sound measures to avail customers’ deposits. Banks need to undertake measures towards the attainment of optimal contracts that can facilitate the stability of banks.
Theoretical Literature Review
Principles of liquidity risk management in banks
Liquidity is associated with the ability of a bank to meet its obligations on time while at the same time funding increases in assets- without incurring unnecessary losses. Banks are inherently susceptible to liquidity risks due to their nature of business; maturity transformation of short-term deposits into long-term loans (Basel Committee on Banking Supervision, 2008). All financial transactions have some underlying implications on the liquidity of a bank. By undertaking effective management of liquidity, it is possible to ensure that a bank is able to meet its obligations related to cash flow. However, uncertainty is always associated with cash flow obligations of a bank as they depend on diverse external events and behavior of other agents. The management of liquidity risk is highly important and relevant in that any shortfall in liquidity in one bank may lead to repercussions throughout the entire financial system. Moreover, the recent developments in the financial markets have further increased the complexity of management of liquidity in banks.
The global financial turmoil that began in mid 2007 demonstrated the crucial role of liquidity in the effective functioning of financial markets and particularly the banks. Before the crisis, there was a progressive buoyancy of asset markets and readily available funding at very low cost. Suddenly, the market condition was reversed indicating the quick nature of liquidity to evaporate leading to an extended period of liquidity problems. During the 2007 -2008 global financial crisis, action from the central bank was required to offer support on the money markets and individual institutions in some cases. A publication released by Basel Committee on Banking Supervision in February 2008 indicated that most banks were unable to account for various principle of liquidity management often considered basic in the system. Indeed, the vast majority of the banks considered most exposed lacked an adequate framework that could satisfactorily account for various liquidity risks associated with business lines and respective products. Consequently, there was a misalignment of business level incentives hence banking increasing high levels of risk tolerance.
Further, there was a failure by most banks to consider the amount of liquidity that would be needed in situations of contingent obligations. In fact, there was a general perception by most banks contractual and non-contractual contingent obligations were highly unlikely to occur. It was far from the imagination of many banks for an event resulting to prolonged severe disruptions in liquidity to occur (Basel Committee on Banking Supervision, 2008). Besides such events being regarded as implausible by many banks, there were no measures to conduct stress tests to factor in the likelihood of the market experiencing widespread strains. There was an absence of Contingency funding plans (CFPs) being appropriately linked to tests obtained from stress assessments. They also failed to put into consideration the possibility that some sources of funding could close at some point in time.
Management of liquidity risk in banks has to integrate sound practices. It is important to undertake significant expansion of various key areas such as establishment of liquidity risk tolerance, maintenance of adequate liquidity through such means as cushioning liquid assets, liquidity costs allocation in significant activities of the business, identifying and measuring full range risks associated with liquidity, designing and using scenarios of severe stress tests, undertaking robust and contingency funding plans that are operational, managing intraday risks associated with liquidity and finally, disclosing information publicly to uphold discipline in the market. The management of liquidity risk in banks also involves supervisors whose main role is to assess whether there are adequate measures to prevent banks from plunging into serious liquidity risks (Basel Committee on Banking Supervision, 2008). Effective cooperation among key stakeholders is important as it leads to fast intervention and prevention of incidences of liquidity risk from plummeting into full pledged crisis.
It is the responsibility of a bank institution to adopt sound liquidity management tools. In the wake of possible uncertainty over the liquidity of a bank, it is essential for adequate measures to be put into place to adequately deal with such instances. Indeed, robust liquidity risk management measures should be adopted by all banks to uphold sufficient liquidity at all times. Additionally, a bank should always cushion unencumbered and liquid assets regarded to be of high quality. This is especially important as it enables the bank to withstand widespread events of stress such as those associated with impairment or loss secured and unsecured sources of funding (Cozzi & Giordani, 2004). Banks should always maintain adequate framework for liquidity management. Such a measure is important as it prevents the possibility of depositors’ incurring losses and protects the financial system from potential collapse.
The management of liquidity risk should also involve clear articulation of the liquidity risk tolerance level by a bank. This is important in that it facilitates bank’s business strategies to be in line with proper and effective functions of the financial system. Strategy development, policy and practices formulation should accompany all other principles of liquidity risk management by bank’s senior management. Such practices and policies should be consistent with the level of liquidity risk tolerance in order to maintain sufficient liquidity. It is the responsibility of the senior management of the bank to always review information pertaining to the liquidity of the bank. The review reports should also be made available to the board of directors on regular basis (Basel Committee on Banking Supervision, 2008). Upon receipt of the liquidity reports, the board of directors should always undertake a review and approval of the strategies, practices and policies on liquidity risk management on a regular basis say semi-annually or annually. This is important as it ensures that the senior management is able to manage liquidity risk effectively. The board of directors can therefore ensure the management does not engage in highly risky behavior.
The role of any financial system in a country is the provision of infrastructure that allows surplus resources to companies and individuals with deficits. The financial markets identify, price and allocate risk. A well functioning financial system is highly important in an economy as it leads to economic growth and development. Weak financial systems often result into breakdowns of the economy leading to widespread distress and ultimately collapse of the entire system of finance in an economy. Policymakers should therefore consider the role of preserving financial systems as a critical one at all times. Kelly (1993) argues that “a financial system is a closely interlinked system of financial relationships based extensively on confidence and trust by all participants and in which the danger of a domino effect, is to be resolutely regarded against by a country’s regulatory authorities. This progressive self-inducing collapse resulting from institutional or market failure would cause the public to lose confidence in the financial system.” (Kelly, 1993 p. 227).
According to IMF reports, the past decade and half has been characterized with numerous banking crises among the member countries. Consequently, most of the member countries have adopted deposit insurance legislations in order to protect the financial systems from bank failures. Indeed, the importance of the banks in a country’s financial system is unquestionably immense. Nevertheless, measures towards insurance of depositors’ funds are not as easy as they may seem on paper. Primarily, banks are businesses with an aim of maximizing profits through the existence of market uncertainty. They therefore take chances on numerous occasions through imprudent actions and overextensions. A smooth running economy is a function of well functioning banks and other participants in financial system. There is no economy that can operate smoothly without the banks. The main question, therefore, is whether the society should underwrite the risky decisions undertaken by banks unconditionally. In a nutshell, this would be rewarding folly. It is the role of government authorities to be clear on assuring the health of a banking system and encouraging reckless behavior on the part of banks. There are pitfalls and benefits of undertaking deposits insurance in that if they are ill-conceived, they could have serious impacts on the economy.
For a bank to avail customers’ deposits on time especially during the periods of uncertainty and panics regarding the liquidity of the bank, effective liquidity risk management strategies need to be put in place. There is need for bank’s management to incorporate liquidity costs, benefits and risks in the pricing and measurement of performance whenever new products are being approved. The measurement and evaluation of such risks should involve both-on and off-balance sheet activities. The outcome of such an undertaking is that there is an alignment of the incentives for risk-taking behavior of individual banks to the level of risk exposures created by the activities undertaken. In the assessment of the risk level of a bank, it is imperative that a bank carefully considers the level of soundness of the activities it is engaged into. It is essential that appropriate measures are undertaken in such a way that the bank is able to identify, measure, control and monitor liquidity risk. It is essential to incorporate robust framework that comprehensively projects the cash flows obtained from the assets of the bank as well as other funding needs that exist across diverse entities, currencies, business lines and also the legal, operational and regulatory environment that affect liquidity transferability.
It is the responsibility of a bank to establish a funding strategy in order to provide effective diversification of tenor and sources of funding. It is imperative that it provides an effective and ongoing presence especially in the chosen markets as well as strong relationships with the providers of funds as it will facilitate the successful diversification. It is prudent that a bank identifies the main factors affecting its ability to raise funds and monitor the factors to ensure fund raising capacity estimates are always valid. It is important to manage the intraday liquidity positions actively so as to ensure settlement and payments obligations are made on time either during normal or distressed conditions. Liquidity risk management also involves active management of collateral positions, differentiation of unencumbered from encumbered assets as well as monitoring physical location of collateral with the legal entity of the bank. Additionally, formal contingency funding plans (CFP) should be in place at all times (Basel Committee on Banking Supervision, 2008). Such plans need to outline policies through which numerous stress environments can be managed. Similarly, it is essential for a bank to have cushions for unencumbered assets in place.
Empirical Literature Review
D-D model of uncertainty and bank runs
Starting from the seminal Diamond and Dybvigis (D-D, 1983) paper, a stream of literature has developed which looks at bank runs as phenomena originating from a coordination failure driven by an extrinsic random variable, namely a sunspot. D-D have in fact constructed a simple banking model in which the optimal demand deposit contract gives rise to two equilibriums: a good equilibrium, in which depositors truthfully reveal their type (impatient or patient) and act accordingly (run or wait); a bad equilibrium (bank run), in which all depositors, independently of their type, decide to run to the bank, driven by an irrational shift of expectations which makes them believe that everybody else is running. If there is no aggregate uncertainty, meaning that if the bank knows how many patient and impatient populate in the economy, then the total suspension of convertibility (TSC) eliminates the bank run equilibrium. Under aggregate uncertainty TSC is not implementable simply because the bank does not know where to stop in returning deposits. The alternative solution proposed by D-D is the deposit insurance.
Wallace (1988) has however criticized the feasibility of the optimal contract under aggregate uncertainty designed by D-D by arguing that through the model, the sequential service constraint (SSC) is indeed not taken seriously. This is particularly because D-D model proposes a solution under aggregate uncertainty that requires a bank to search for an optimal contract as a function of the proportions of the patient and impatient depositors which the bank does not have a clue about. Further, the D-D model proposes that after each depositor contacts the bank for the revelation of their identity, the bank is able to develop the proportion levels of depositor types. The knowledge of the proportions of patient and impatient by a bank, according to D-D, enables the implementation of an optimal contract. Wallace (1990) has then proven that, under aggregate uncertainty and SSC taken seriously, partial suspension of convertibility (PSC) characterizes the optimal banking contract, because it enhances the risk-sharing among depositors.
In enlarging the set of feasible contractual arrangements from the simple contracting to a class of banking mechanisms that allow for suspension schemes Wallace (1990) has brought about a significant departure from the original D-D framework and has inspired a number of subsequent works in this field. An important contribution along these lines is Peck and Shell (JPE, 2003) which designs a banking model admitting a multiplicity of equilibriums and further develops the issue of the selection among them. Peck and Shell (2003) can be interpreted as a response to the banking model developed by Green and Lin (2000), whose optimal mechanism only admits the good equilibrium. Peck and Shell (2003) in fact, show that the non-existence of the bank run equilibrium in Green and Lin (2000) crucially depends upon the unrealistic assumption that depositors know exactly their position in the bank and that bank run equilibriums re-emerge as soon as depositors are assumed to have only a probabilistic knowledge of their place in line.
The banking model developed in Peck and Shell (2003) is characterized by aggregate uncertainty on the distribution of the agent’s type and by the observance of the sequential service constraint which forces the bank to deal with customers sequentially. Cozzi and Giordani (2004) view bank runs as rare events which are often characterized with very high pessimistic attitudes from depositors. They undertook an analysis of a scenario whereby depositors portray uncertain tendencies about bank runs. Their study (Cozzi and Giordani, 2004) sought to check whether bank runs are likely to occur especially in areas where depositors have maxmin decision making approaches. Furthermore, the study assessed the schemes of utility suspension in the contexts of pessimistic bank runs. Therefore, Cozzi and Giordani concluded that banking mechanisms provide a critical immune to sunspot-induced runs. In particular, strong uncertainty and very conservative attitudes of the consumers prevent bank runs. The implementation of suspension schemes in banking contracts are encouraged as important means through which uncertainties and panics among depositors can be managed.
Implications of Moral Hazard on Deposit Insurance  
There is a tightrope nature of deposit insurance. While explicit deposit insurance can significantly reduce the incidence of bank runs or even stop runs altogether in countries with strong institutions and proper safeguards, it can also fuel bank crises by giving banks perverse incentives to take unnecessary risks when not done carefully (Demirguc-Kent & Kane 2002). For instance, the U.S. learned a very painful lesson during the 1980s and 1990s for not undertaking deposit insurance carefully. Indeed, any country that adopts explicit deposit insurance must grapple with the destabilizing effects of that insurance on the country’s financial system. Moral Hazard is a problem that originates from explicit deposit insurance. Until recently, the question of proper safeguards was strictly a matter of theory and not of empirical fact. In recent years, however, two new datasets on deposit insurance schemes around the world – the first compiled by World Bank economists Asli Demirgüç-Kunt, Baybars Karacaovili, and Luc Laeven and the second compiled by economists James R. Barth, Gerard Caprio, Jr., and Ross Levine (The World Bank, 2001). The two datasets have greatly enriched the understanding of the effects and limitations of various facets of deposit insurance.
Clearly, deposit insurance does not offer a solution to banks susceptible to depositors’ runs. When there is a strictly positive probability of a panic, banks can best invest a little more in the short-term technology because this increases the resources available in case such an event occurs
Discuss how a firm can ensure customers’ deposits are sound and available in the context of uncertainty, deposits-bank panics and moral hazards.
Further explain how banks can achieve optimal contracts.
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Wallace, N. (1998). Another Attempt to Eplain an Illiquid Banking System: the Diamond and Dybvig Model with Sequential Service Taken Seriously. Federal Reserve Bank of Minneapolis Quarterly Review, 12, 3-16.
Wallace, N. (1990). A Banking Model in which Partial Suspension is best. Federal Research Bank of Minneapolis Quarterly Review, 14, 11-23.  

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