On 14 September 2007, long queues formed up and down the UK outside branches of the Northern Rock Plc. bank, as anxious customers waited to withdraw their savings.
In the space of a few days, billions of pounds were drained from the accounts of savers panicked by Northern Rock’s recent request for assistance from the Bank of England, in its capacity as a lender of last resort.
Dimitrios Tsomocos is a university lecturer in financial economics at Saïd Business School, University of Oxford
With a banking crisis occurring at least once a decade since the 1970s, it seems all too common a problem. Together with Charles Goodhart, a renowned economist and member of the Bank of England’s Monetary Policy Committee from June 1997 to May 2000, we are developing a new model of financial fragility which, when fully developed, may help bring some stability to banking systems around the world.
For a large part of the 20th century, banking systems were relatively stable. “There was a massive period of instability in the interwar period in 1929-1933,” says Goodhart. “As a result, bankers became more cautious. Banking became highly regulated, with all kinds of controls over lending, which meant the banks became very safe, but not very innovative.”
From the 1960s onwards, however, a variety of interested parties began to lobby for deregulation. “Direct credit controls on banks were removed in the course of the 1960s, 1970s and early 1980s, which made the banking system more innovative, but also riskier,” says Goodhart. “The number of bank failures was very low between 1935 and 1975, and only really increased from the 1980s.”
Since the relaxation of banking regulations, systemic financial crises have mounted: the UK’s secondary banking crisis of 1973 and 1974; the US’ savings and loans scandal of 1985; the stock market crash of 1987; the Asian financial crisis of 1997 and the ensuing banking crises in Brazil and Russia in 1998, followed by the collapse and rescue of hedge fund Long-Term Capital Management; the bursting of the dot-com bubble in 2000; and now the subprime mortgage crisis.
As the Bank of England’s intervention in the case of Northern Rock demonstrates, one role of central banks is to maintain monetary stability, avoid inflation, and maintain and oversee the efficient working of financial markets through such crises.
“Think about the macro monetary policy of a central bank and the inflation target. The bank has a model enabling it to measure inflation and predict how it is likely to develop. It also has an instrument to affect inflation—the interest rate,” says Goodhart. “Move on to problems about financial stability, however, and we don’t really have a model which enables us to analyse financial stability. We don’t have a metric to measure financial stability. We can’t really predict financial stability and we don’t really have a very good instrument to affect it.”
Since 1998, we have been working on a model to remedy this situation. It is cutting edge financial research at the interface of microeconomics, finance and mathematical economics. The idea is not to assess or investigate banks individually, but to investigate how banks interact with other banks via the inter-bank markets, where financial institutions borrow and lend money to each other.
(Illustration by: Malay Karmakar /Mint)
We put special emphasis on modelling the inter-bank market, and emphasizing the heterogeneity and diversity of interactions among banks, and how the corresponding inter-bank exposures may accelerate and magnify any individual shock from within the system to any single bank.
The Northern Rock situation is an example of why a systemic approach is essential. Northern Rock’s problems arose as a knock-on effect of a subprime mortgage crisis in the US. Low interest rates encouraged risky, unsecured mortgage lending, including so-called Ninja loans—to people with no income, no job or assets. This—coupled with a financial innovation involving lenders repackaging and selling on those loans, and then widespread default by borrowers—created a situation of uncertainty.
Northern Rock’s business model relies on borrowing money in the inter-bank market, but uncertainty in the market meant few banks wanted to lend. Unable to raise money on the wholesale markets, or get its borrowers to repay their mortgages any faster, it was faced with an unfundable “maturity mismatch”, and so turned to the Bank of England.
A unique aspect of the Goodhart-Tsomocos financial fragility model is how it looks at the entire banking system in totality, not as isolated units comprising individual banks. Importantly, unlike other models, the Goodhart-Tsomocos model includes the default of loans caused by events within the system—endogenous default. Any financial instability is some sort of discontinuity in the system, so any model that cannot capture the interactions and cannot model endogenous default and liquidity, is at risk of miscalculation.
By looking at the interaction between banks, we are developing a two-factor metric that, through assessing the probability of default and percentage changes in banking sector values, can factor in knock-on effects, and mimic the functioning of the financial markets. Thus, the model can be used to search for indicators of a possible impending financial stability crisis, and for crisis prevention and management.
In the final analysis, we need to learn how to live with financial instability and develop the appropriate policy responses.
The model has been calibrated and tested using data from a number of central banks, including the Bank of England, the Bank of Japan, and the Bank of Colombia. More research is required, but we are on our way to providing central banks with an invaluable tool that may prevent future financial crises, including the scenes of panicked savers queuing along the street, desperate to withdraw their money.
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