How to prevent another Northern Rock

RES logoCrisis regulation may help avoid another Northern Rock style panic, according to research by Professors Shurojit Chatterji and Sayantan Ghosal presented at the Royal Economic Society’s 2008 annual conference.

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But the authorities should not always aim to prevent bank runs on the contrary, when regulators cannot monitor banks and fine those that are behaving irresponsibly, the possibility of bank runs is needed to prevent banks from lending irresponsibly in the first place.

In September 2007, Northern Rock suffered the first bank run on a British bank in over a century. The spectacle of depositors queuing up in front of the high street branches of the Northern Rock has prompted much commentary on the stability of the financial systems and the global consequences of the subprime crisis in the United States.

Bank runs are driven by coordination failure: if each depositor fears that other depositors are about to withdraw their deposits, they rush to withdraw their deposits before the bank runs out of cash.

Preventing bank runs driven by depositor coordination failure can be achieved if each individual depositor can be credibly assured that even if all other depositors withdraw, their deposits will continue to be safe. The British government gave such a guarantee to depositors in Northern Rock.

The report shows that without effective regulation, the risk of a bank run is required to stop reckless lending by banks. Even though depositors know a bank run might occur, they still deposit their wealth with banks as the benefits from doing so are potentially greater than the risks. So banks improve on a situation with no savings at all, but they also create the risk of a crisis.

Although intervention by central banks or government agencies takes place typically after the onset of a crisis, the report recommends a policy framework where plans for a contingent intervention regime are put in place before a crisis breaks.

Such an intervention regime would involve a prior commitment by a public authority (such as a central bank or a fiscal services regulator) both to monitor bank actions if liquidity suddenly dried up and followed this by a threat of fines if irresponsible behaviour is revealed.

The report shows that the threat of monitoring and confiscation of bank payoffs deters opportunistic behaviour, even before any crisis breaks. In this way, the regulatory authority can reduce costly intervention after a crisis such as guaranteeing each individual deposit.

In addition, the government would not necessarily have to regulate all banks in a liquidity crisis: just those that were judged to be most at risk (as Northern Rock, with its limited depositor base was).

Notes for editors: Liquidity, Moral Hazard and Bank Runs by Shurojit Chatterji and Sayantan Ghosal was presented at the Royal Economic Society conference at the University of Warwick, 17-19 March 2008.

Shurojit Chatterji and Sayantan Ghosal are at the University of Warwick.

For further information: contact Sayantan Ghosal on 024 7652 3042 (email: S.Ghosal@warwick.ac.uk); Shurojit Chatterji on 024 7657 5749 (email: Shurojit.Chatterji@warwick.ac.uk); or Romesh Vaitilingam on 07768 661095 (email: romesh@compuserve.com).

Read more papers by Sayantan Ghosal at EconPapers and search for more Internet resources at Intute: Social Sciences on the topic of banks and banking.

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