Financial stability and government bonds

Yearbook article 2016, Max Planck Institute for Research on Collective Goods
Authors: Stephan Luck and Paul Schempp

June 14, 2016

Banks typically grant long-term loans, but their liabilities are short-term. While this maturity transformation is one of the main features of banks, it also constitutes a major risk factor. A research project at the Max Planck Institute for Research on Collective Goods shows that a strong government can reduce the refinancing risk of banks by providing them with government bonds. In case of countries that are financially interconnected, all parties might benefit if the strong country protects weaker ones by forming a banking union.

Banks are financial institutions which fulfil a variety of financial functions such as providing payment services. One of their main functions, which also contains a high degree of risk, is to play the role of the middleman between investors and borrowers by undertaking the maturity transformation. On the one side, we have a demand for liquid investment opportunities: many private individuals and companies would like to invest their resources with short-term availability as they do not know exactly when they will need these funds for consumption or investment. On the other side, many borrowers require long-term finance. These can be both companies with long-term investment projects and private individuals who wish to buy a property.

What is this maturity transformation exactly? A bank can raise funds from investors in the form of demand deposits and lend them in the form of long-term loans. While the bank therefore has long-term investment projects on the assets side of its balance sheet, the liabilities side shows short-term liabilities as demand deposits that can be withdrawn by investors at any time, meaning to all intents and purposes that they are due at all times. The bank needs liquid funds in order to serve withdrawing investors. To this end, it can either keep part of its funds in storage, or it can generate short-term funding through investors on the money markets. The latter option is more attractive than physically storing liquid funds.

Fragile banks

There are two mechanisms which make the maturity transformation described unstable. The first is a classic bank run where all investors want to withdraw their demand deposits with the bank at the same time [1]. As the bank does not have sufficient liquidity and is unable to raise enough liquid funds on the money markets to service all investors immediately, the bank run makes it insolvent. This represents a banking crisis based on self-fulfilling prophecies, as  for each investor - in expectation of this event - it is individually optimal to be one of the first at the bank counter so that he receives his money before the bank runs out of funds. There is therefore a strategic complementarity between the different investors: if all the investors threaten to withdraw their funds, the rational reaction for each individual investor is to follow suit. Credible deposit insurance can break through this strategic complementarity and thereby prevent bank runs. While bank runs occurred again and again up until the global financial crisis in the 1920s and 1930s, the deposit insurance systems put in place since then have been very effective in preventing bank runs.

A bank run is not the only risk for banks, however, as evidenced by the numerous banking crises that have occurred in the last 60 years. In the case of the maturity transformation described above, the second mechanism results from the bank's refinancing risk: in fact the strategic complementarity between the potential providers of capital to the bank on the money markets is similar to that between investors. If the former believe that the bank is threatened with insolvency, the interest rates that the bank has to pay, will rise. This can turn the fear of insolvency into a self-fulfilling expectation. Deposit insurance cannot avert this as it only protects previous but not potential future investors. The main problem is that potential investors cannot make a binding commitment in advance to provide liquid funds in the future. Any such collective undertaking would cancel the strategic complementarity.

Strong country: Financial stability through government bonds

There are various approaches to limiting this refinancing risk. The recent bank regulations (Basel III) contain requirements on liquidity as well as equity: they state that the more short-term liabilities a bank has, the more liquid asset positions it must hold. However, such rules limit the maturity transformation described above and reduce its efficiency.

Nevertheless, there is also one mechanism that stabilizes the maturity transformation without any detrimental effect [2]. This mechanism brings the state into play as it is the only agent in a country's economy that can credibly guarantee future liquidity [3]. The mechanism proposed is based on maintaining the optimum maturity transformation as described above. The liabilities side of the bank's balance sheet containing short-term liabilities (demand deposits), is extended in the process to include long-term liabilities towards the state. In the same manner, the assets side of the bank's balance sheet with its long-term loans is extended to include government bonds with the same maturity as the liabilities. These government bonds are tradable; and instead of obtaining funding on the money markets, a bank can now sell its government bonds. This cuts through the strategic complementarity described above: buyers of the government bonds acquire a receivable from the state, and the latter is always in a position to meet its obligations towards the owner regardless of whether other players are also prepared to buy the government bonds from the bank. This extension of the balance sheet, by the way, has no effect on the state's net debt nor on that of the bank.

Weak country: Financial stability through a banking union

This mechanism, however, only works if the state is genuinely strong in fiscal terms. Strategic complementarity reasserts itself if the solvency of a state depends on whether there is a banking crisis - for example, because this will trigger a recession in the real economy, thereby reducing the state's tax base. On the one hand, a weak state cannot promise credible deposit insurance which means that it can no longer prevent a classic bank run. On the other, banks will be unable to sell their government bonds if potential buyers fear a sovereign debt crisis. This can lead to a banking crisis and turn the fear of a sovereign debt crisis into a self-fulfilling prophecy.

Historically, banking crises and sovereign debt crises have often occurred together as "twin crises" [4]. One of the most recent examples of impending, self-fulfilling twin crises was provided by the Southern European countries during the Euro crisis which started in 2010. Many of these countries and their banks (with the exception of Greece) had no fundamental solvency problems but the fear was that they might suffer self-fulfilling crises. These potential crises would also have had a negative impact on stronger Euro countries.

Generally, a sufficiently strong country can preserve weaker ones from crises by giving suitable guarantees. But is there any incentive for it to do so? Such guarantees can in fact be in the interests of all participants, especially in the case of tightly interconnected, international financial systems as is the case with the Eurozone. This can be exemplified by a situation involving two countries [5]. Let us assume two countries only differ in their fiscal strength: one country is very strong in fiscal terms, and the other is weak. Both countries have banks that are holding the government bonds of either country. While the strong country is able to give its bank credible protection through deposit insurance, the weak country may suffer a simultaneous sovereign debt and banking crisis. This will also have a negative impact on the banks in the stronger country as they are holding government bonds from both countries. The self-generating crisis in the weaker country and with it the spread of the contagion to the stronger country could be prevented, however, by means of fiscal guarantees and particularly through a banking union which includes joint deposit protection. For the fiscally strong country, this comes free of charge as the credible guarantee means that it never has to be honoured.

The European banking union currently comprises the Single Supervisory Mechanism for banks and the Single Resolution Mechanism. The supranational deposit insurance originally envisaged has not so far been implemented, however. The reason for this is essentially to be found in the fears harboured by the stronger Euro countries that they will become liable for fundamental problems in other countries. However, it should be remembered that this third building block of the banking union can help to prevent self-fulfilling crisis expectations in the weaker countries and the spreading of problems associated with them.

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Luck, S.; Schempp, P.
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