Banking Sector Essay -- Financial System, Bank Runs

Traditionally, the existence of bank runs was a very frequent phenomenon in Europe during the 19th century. It was mostly seen in the emerging countries where the boeotian level was low. Kaminsky and Reinhard introduced a new concept in the banking sector called twin crises. The twin crises concept started since 1980 and occurs when both currency and banking crises take place simultaneously. This harmful phenomenon anticipated a significant recession after the 1933 when the Federal Reserve System imposed the concept of Deposit Insurance in the US. In the same directions all governments around the world tried to find ways to prevent crises. Several schemes like the Suspension of convertibility and penalty on short-term deposits followed the implementation of Deposit Insurance scheme. As a result of the establishment of these new schemes, policy makers and bankers focused their attention and criticism on the recent concept of moral hazard that came into surface during the savings and loan crisis of 1980. In order to begin analyzing the macroeconomic concept of bank runs I have to mention that there are literally two general views. The first group of economists such as Diamond and Dybvig (1983), Chang and Velasco (2001) and Cooper and Ross (1998) supports that bank runs are self-fulfilling prophecies, unconnected to the real economy of the country. Under this view, if agents do not expect a bank run to take place, the risk-sharing mechanism of the banking sector operates beneficially and an efficient allocation of resources is achieved. On the other hand, if the agents believe that a bank run will occur then they will all have the tendency to run and withdraw their money as soon as possible to avoid losing them. The second appr... ...mplementing the 5 regulatory policies as I mentioned above at the end of the first part of this paper. The Diamond and Dybvig model clearly explains why these five policies were introduced. Firstly, the suspension of convertibility was introduced in order for events like the example of the bad equilibrium be avoided and keeping the bank alive. On the same line was introduced the tax on short-term deposits as well in order to disencourage depositors to withdraw their money early. In addition, the FCDI scheme was implemented in order to remove the fear of a bank run from the investors to eliminate the occurrence of panic within the financial market. Furthermore, the ICDI scheme was introduced to eliminate the concept of moral hazard that is caused by FCDI. Finally, the capital requirement scheme was established in order to keep the banks more liquid and solvent.