Bank runs and TARP

This is a Hand post, but it is actually just the normal authors of the blog.  We all had the same idea at the same time 😀

Over at Anti-Dismal, Paul Walker reaches the conclusion that

The moral of the story, markets can deal with asymmetric information

In the case of bad and good banks.  He states that banks are able to signal whether they are strong or not, and so government intervention is unnecessary.

However, this doesn’t seem to weigh up properly with the vast amount of literature that points out that bank runs are a concern resulting from asymmetric information (and multiple equilibrium – for economists this is because withdrawal decisions are strategic complements) and that a small amount of government intervention can help prevent said negative outcomes (here and here are seminal pieces).

Now there is a way that we can put both points of view together. Lets look at how the market is overcoming the asymmetric information problem:

At least one major US bank is advertising the fact that it refused TARP funds.

So the market was only able deal with asymmetric information in this case because the government created a mechanism that allowed banks to credibly signal (the TARP program).  It is ONLY because the government created this mechanism that the individual banks could signal their “strength” credibly, thereby preventing an inefficient bank run equilibrium.

So I would change the moral of the story slightly to

markets can deal with asymmetric information, when the institutions are in place that allow them to credibly signal quality – an issue government can sometimes help with

  • Now just hang on there. The point I was making was that the market was undoing the what the government had done. Remember that the government insisted that all large banks take the TARP money to avoid tainting those banks that actually needed it. In other words the government was trying to stop signalling by banks as to their state of financial health. Now the banks are finding ways around this government created lack of information. The government does not want people to know the true state of the banks financial situation but the banks do want this known. At least the healthy ones do. Had the government not tried to stopped this information being made public banks would have found other ways of revealing it. Government intervention is not needed for banks to signal their health, its in their own best interests to do this. In fact the government intervention was to try and stop people knowing this information.

  • “Government intervention is not needed for banks to signal their health, its in their own best interests to do this. In fact the government intervention was to try and stop people knowing this information.”

    But the problem is that the signal isn’t credible. The bank’s can’t credibly signal their health – so the healthy banks get dragged down with the unhealthy ones.

    The existence of TARP provided a mechanism that allowed a credible signal. The Fed needed to make all banks take it on in order to reduce the chance of a run on banks originally, but I get the feeling they don’t mind that some banks are using it to signal quality now.

  • The key point is that you can only have a credible signal if there is a separating equilibrium. Normally there isn’t, but the existence of a TARP created one.

    And not only that, the government made money off it.

  • @Paul Walker
    “Talk is cheap” as they say.

    Even the unhealthy banks have an incentive to say they are healthy. Without the TARP there is no seperating equilibrium since both “types” have the incentive to say the same thing.

  • @agnitio

    Indeed, but the choice about whether to take the TARP will differ based on the health of the banks – allowing a separating equilibrium of the sort that we now seem to be observing!

  • indeed:)

  • TARP was set up in such a way as to prevent signalling. The government used it to stop banks from using whatever method they like to signal their financial health. The same issue arose when several big banks wanted to repay their loans. The government didn’t want them to do so because it would show who was able to, and thus healthy, and those who couldn’t. The whole point of the government intervention was to stop signalling.

  • @Paul Walker
    I think our point is that TARP couldn’t stop signalling because the banks had no way to signal prior to TARP. The fact that they couldn’t signal meant that there could be a run on healthy banks, which posed a risk to the economy.

    The implementation of TARP allowed for a separating equilibrium, which would have risked a run on banks that chose to take government money to prop up their balance sheets. Since banks would have risked destruction by initially taking the money, yet the money was needed to reinforce the banking system, it made sense to enforce a pooling equilibrium and prevent the use of TARP as a signal.

    Now that the hysteria has died down there isn’t the same risk of a run on banks involved in TARP. That means that the government has been able to relax its position on using TARP as a signalling device and a separating equilibrium may be forming.

    To suggest that TARP was implemented to prevent signalling misunderstands the counterfactual situation. Without TARP there was no credible signal of quality, which is why the banks needed the support in the first place.

  • Banks have always had ways to signal their health. Why was it for many years banks always had such grandiose buildings? It wasn’t just because they liked the look of them. Most are bloody awful. It was a signal. TARP was designed to stop signalling. The government didn’t want banks to be able to signal. That is why they said all banks had to take the money and why they didn’t want banks to pay the money back. Even now the government doesn’t want the banks to say they didn’t take the money. They are still trying to prevent banks from signalling. The fact that banks are now using a system designed to stop signalling to signal is my point. The market has come up with a way to deal with asymmetric information by using a scheme created to enforce asymmetric information.

  • @Paul Walker

    Paul. Banks have always wanted to signal that they are high quality – even when they weren’t. As a result, the signal wasn’t credible.

    Hence, in the event of a big shock to banking system confidence we can get an inefficient bank run. The TARP was designed to prevent this type of bank run, and as a result was made universal so as to prevent funds shifting from banks that were normally in good health but would have needed TARP funds temporarily (as opposed to banks that were just in straight trouble).

    Now that the banking crisis has abated, they are letting the market use the TARP as a signal – as that way we can ensure that the worst banks still have to shut down, the medium banks will operate, and the best banks get rewarded. This isn’t a sign that government policy was wrong – it is a sign that policy was flexible and appropriate, a surprising result but a good one.

    So with TARP they prevented bank failures, and then allowed the best banks to have a credible signal of quality – man it just sounds like a better and better policy by the day 😀

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