Two Views on Banking Crisis - 0 views
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Jass Tpss on 20 Apr 11As banks continue to fail, there is a renewed interest in understanding the causes of financial crisis. Economists have for long tried to understand what causes such crises. There are two views on this: (a) a "sunsopt" view, and (b) a "business cycle" view. The sunspot view argues that the root cause of crisis is depositor "panic". When a substantial number of depositors of a bank begin to believe that a bank is not solvent, they end up starting a self-fulfilling bank run. Given the first-come first-serve nature of demand deposit contracts, every depositor wants to stand first in the line to withdraw his money from the bank. This collective action puts a pressure on even an otherwise solvent bank and drives it to bankruptcy. The business cycle based view instead focuses on fundamental weaknesses in the economy as the key force behind a banking crisis. Under this view, economists argue that banks fail because their illiquid risky investments turn out to be bad. Depositors realize this problem and therefore demand their money back. This leads to an "inefficient" liquidation of the bank and its ultimate failure. While these two views share several common feature, there are many differences in their policy prescriptions. Under the sunspot view, the regulator should try hard to avoid a self-fulfilling prophecy. Regulations such as deposit insurance from the government are geared precisely toward avoiding such runs. Under the business cycle based view, the regulators need to focus their attention more closely on avoiding risky bank behavior and in ensuring smooth liquidation of distressed bank's assets. Of course, a prudent bank regulator should use elements of both these theories to design an optimal bank regulation policy.
