“Potter’s not selling; Potter’s buying. Why? Because we’re panicking and he’s not!”  – George Bailey

We all remember the scene in “It’s a Wonderful Life” when James Stewart (as George Bailey) tries to stave off a run by nervous depositors at his Bailey Bros. Building and Loan while, across town, financier Mr. Potter looks to swoop in at fire sale prices. These days, according to a panel of economists at Monday’s CME Group-MSRI Prize in Innovative Quantitative Applications seminar, it may well be the Mr. Potters of the world who touch off a bank run.

More on that in a moment. But first, here is a little about the annual prize awarded this year to University of Chicago finance professor Douglas Diamond.  In 2006, CME Group teamed up with the Mathematical Sciences Research Institute (MSRI) to “reward exemplary work in the field of mathematical sciences and recognize the vital impact quantitative research and application play in shaping global financial markets.” Several past CME-MSRI winners, including Thomas Sargent, Jean Tirole, Robert Shiller and Lars Peter Hansen, have gone on to receive the Nobel Prize in Economics. Perhaps this bodes well for Prof. Diamond. For more on the prize and its past winners, click HERE.

Monday’s panel discussion included several leading voices in the field of financial market structure, fragility and liquidity crises. All cite Diamond’s work with Philip Dybvig in 1983, “Bank Runs, Deposit Insurance, and Liquidity” as having set the standard model for analyzing bank panics. According to Yale’s Gary Gorton, the Diamond-Dybvig work was “the first coherent model explaining the concept of a bank and its link to the real economy.” He says the model demonstrated why the nature of a bank is to take in short-term deposits, available on demand, and lend out for long-term projects, and this “maturity transformation” function is quite efficient, but also makes banks fragile and vulnerable to shocks.

So why did I drag George Bailey and Mr. Potter into the mix? The answer lies in the rise in shadow banking, the nonbank financial system that sprouted up in the last 20 years to help  banks more efficiently navigate this maturity transformation process by smoothing out liquidity needs. According to Diamond, banking crises are “always and everywhere due to problems of short-term debt,” and the trick becomes finding it during a crisis. Shadow banking, which includes vehicles such as repurchase agreements (repos), securitizations, and asset-backed commercial paper, is essentially a shared pool of short-term funding, and this pool can dry up when it is most needed. And according to University of Chicago’s Lawrence Schmidt, who also served on Monday’s panel, in the era of shadow banking, it is the actions of savvy sophisticated investors, not panicked retail depositors, who touch off a run.

Schmidt’s research looks at money market funds, specifically during September of 2008 when Lehman Brothers filed for bankruptcy and the Reserve Primary money market fund, which had invested heavily in Lehman paper, “broke the buck,” meaning its net asset value (NAV) fell below the minimum funding level that guaranteed the full value of depositors’ principal. Schmidt says that increasing the number of sophisticated investors leads to larger redemptions, more quickly, and a greater likelihood of breaking the buck. Panelist Itay Goldstein of Wharton agrees and says a first mover advantage can and does amplify redemptions, and that the advantage is more severe when a fund holds more illiquid assets.

So what can we in the derivatives world take from this discussion? It is a reminder that, in the era of interconnected markets, there is a limit to the effectiveness of prudent risk management and efficient liquidity matching. When a systemic event occurs, in the aggregate, that loss must be borne somewhere. It may not be enough to be hedged on paper. The key is to create systems – capital, payment and settlement, regulation and oversight – that address this interconnectedness, and these systems must include all parties. To exempt large segments of the market would be like, in the words of Prof. Diamond, “addressing a fire on the 23rd floor by installing fire extinguishers on the 23rd floor only.”

I am also reminded of the power of central counterparty clearing, the model that has served the listed derivatives markets well, through all of the crises discussed Monday. As more and more nonbank activity comes out of the shadows and into central clearing, let us hope the clearing model stays true to its roots in terms of scale, collateralization and risk monitoring. Because the best cure for a run on the bank (or nonbank) is not having one in the first place.

Not even mean old Mr. Potter can argue with that one.  

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