Academic journal article Journal of Economics and Economic Education Research

Explaining the Interbank Loan Crisis of 2008: A Teaching Note

Academic journal article Journal of Economics and Economic Education Research

Explaining the Interbank Loan Crisis of 2008: A Teaching Note

Article excerpt

INTRODUCTION

One unintended consequence of the financial crisis of 2008 is a heightened student interest in economics. Having recently given a student-requested afternoon symposium on the topic to a standing-room-only crowd (a new experience for these economists), we find ourselves in a teaching moment--where students are getting a glimpse at the importance of economics in their lives, and demanding a reasoned explanation of the crisis. The intent of this note is to supply a response to our students' demand.

In this paper, we examine one aspect of the financial crisis: the month-long turmoil in the interbank loan market. The crisis began with the bankruptcy of Lehman Brothers on September 15, 2008 and ended with the U.S. Treasury Department's $250 billion bank recapitalization on October 14, 2008. At the industry-wide level, the crisis was characterized by historic spikes in the federal funds rate (hereafterfr), a shrinking of the deposit multiplier, and the hoarding of excess reserves. At the individual bank level, the crisis was evidenced by unprecedented increases in the market for insurance against bank defaults on debt, known as credit default swaps. All this occurred despite massive injections of reserves by the Federal Reserve Bank (hereafter the Fed) and a 25 percent decrease in the target ffr from 200 basis points to 150.

We model the dysfunction as a prisoner's dilemma in which banks with excess reserves play a game of Loan or No Loan with each other. The initial game results in a Nash equilibrium where each bank chooses No Loan and both are worse off. The second game examines government intervention to revive interbank lending through the lens of an asymmetric information problem. The recapitalization program by the U.S. Treasury department (hereafter the Treasury) is discussed within this context. Two immediate benefits arise from this exercise. First, the model illustrates the key insight of John Nash that rational behavior at the individual level can lead to irrational outcomes in the aggregate. This outcome is particularly prevalent in financial markets where transactions depend significantly upon trust between participants. Second, students get a simple framework in which to analyze proposed government solutions to financial crises. Because financial crises follow similar patterns, this model can be applied to other time periods--such as the U.S. banking crisis during the Great Depression--and other countries--such as the 1992 financial crisis in Sweden. This approach should have broad appeal to economists because no finance or advanced economic theory is required and much empirical evidence supports the results.

BACKGROUND

To understand the economic theory behind the interbank loan crisis, first consider the usual monetary policy prescriptions for a tight credit market. To stimulate lending, the Fed injects reserves into the banking system to lower the ffr. The ffr is the interest rate banks charge one another for overnight lending of excess reserves--that is, reserves above what banks are required to hold against their deposits. These excess reserves are crucial during credit contractions as they provide insurance for banks against deposit withdrawals and declines in the value of bank assets. The ffr changes as banks supply and demand excess reserves from each other. A lower ffr reduces borrowing costs for banks that demand reserves while the injection of reserves expands the supply available. The Fed intervenes in the market every day by buying and selling treasury notes from and to banks to maintain the Fed's target ffr. The Fed's effectiveness is evidenced by the small deviations of the daily high ffr from the Fed's target ffr which averaged 32 basis points for the six years between November 1, 2002 and September 14, 2008. (1)

In addition to lowering the ffr and increasing the supply of available funds for the interbank loan market, an intervention by the Fed has a multiplier effect by which an increase in one bank's reserves, R, can lead to multiple deposits being created throughout the banking system. …

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