Chapter 14: Bank Runs & Liquidity (Sections 14.1–14.5 & 14.7)

Question 1

What are the main tools to prevent traditional bank runs?

Answer 1

Deposit insurance (e.g., FDIC guarantees up to $250,000) removes the incentive for small depositors to panic.

Suspension of convertibility briefly halts withdrawals at a fixed payout rate, reassuring depositors that the bank will survive.

Deposit certificates pay a fixed dividend if withdrawn early or a different claim if held, mimicking deposit insurance through tradable claims.

Question 2

What is narrow banking, and what trade-offs does it involve?

Answer 2

Banks are restricted to holding only the safest, most liquid assets (e.g., government bonds) against deposits.

This eliminates maturity-transformation risk and runs, but pushes riskier lending out into shadow banking (e.g., money-market funds) where it may be less regulated.

Question 3

How do banks measure liquidity risk using a reserves ‘buffer’?

Answer 3

They treat reserves like inventory: choose a level that balances the cost of holding low-yield liquid assets against penalty costs if short.

In practice, many banks underestimated this trade-off before 2007, leading to fire-sales when markets seized up.

Question 4

How does the interbank market help banks manage liquidity?

Answer 4

Banks with surplus cash lend overnight (e.g., Federal Funds or repos) to those facing shortfalls.

Before 2007, this worked smoothly; during the crisis, distrust froze these markets, forcing central-bank intervention.

Question 5

What causes shadow-bank runs in repo-funded institutions?

Answer 5

Shadow banks fund via repos (short-term collateralized loans). If repo lenders fear collateral values will fall, they refuse to roll over funding, triggering a rapid liquidity squeeze.

Example: Lehman Brothers in 2008 saw its repo lines evaporate, leading money-market funds to ‘break the buck’ and freeze interbank funding.

Question 6

In a dynamic model of shadow runs, why do roll-overs eventually fail?

Answer 6

Shadow banks continually issue new short-term debt to repay maturing obligations. Each roll-over erodes available collateral, shrinking future funding capacity.

Example: Structured Investment Vehicles (SIVs) before 2008 survived by rolling commercial paper but collapsed when markets refused new issuance.