Questions and Answers about the Financial Crisis

All bond prices plummeted (spreads rose) during the financial crisis, not just the prices of subprimerelated bonds. These price declines were due to a banking panic in which institutional investors and firms refused to renew sale and repurchase agreements (repo) – short?term, collateralized, agreements that the Fed rightly used to count as money. Collateral for repo was, to a large extent, securitized bonds. Firms were forced to sell assets as a result of the banking panic, reducing bond prices and creating losses. There is nothing mysterious or irrational about the panic. There were genuine fears about the locations of subprime risk concentrations among counterparties. This banking system (the “shadow” or “parallel” banking system) - repo based on securitization - is a genuine banking system, as large as the traditional, regulated and banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created.

Noise Traders

Noise traders are agents whose theoretical existence has been hypothesized as a way of solving certain fundamental problems in Financial Economics. We briefly review the literature on noise traders. The is an entry for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York), edited by Steven N. Durlauf and Lawrence E. Blume, forthcoming in 2008.

Bank Panics and the Endogeneity of Central Banking

Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with many small, undiversified banks, are prone to panics and failures, unlike systems with a few big banks that are heavily branched and well diversified. Systems of many small banks are more efficient if the banks form coalitions during times of crisis. We provide conditions under which the industrial organization of banking leads to incentive compatible state contingent bank coalition formation. Such coalitions issue money that is a kind of deposit insurance and examine and supervise banks. Bank coalitions of small banks, however, cannot replicate the efficiency of a system of big banks.