Why Do Banks Fail Together In A Crisis?

John Carney
CNBC.com

09 Dec 2011
Watching Europe's banks teeter on the brink of disaster because of their exposures to
sovereign debt has an eerily familiar feel to it.

It is very reminiscent of the near death experience of many of the largest US banks in
2008. Back then it was mortgage-related investments rather than government bonds
that weighed down the balance sheets of the banks.

One question that a lot of market watchers have is why bank failures seem to cascade.
Why do we keep discovering that so many banks apparently follow very similar
investment strategies? Don't the banks employ lots of very well paid people to make
decisions about which loans to make, which assets to buy, and where to invest? How
is it they all keep deciding the same thing?

The fact that so many banks buy the same kinds of assets is what makes for a crisis. If
it were just one or two banks that unwisely over-indulged in mortgages or sovereign
debt, the financial system could easily handle their failure. This is why, for instance,
the failure of MF Global didn't provoke a crisis: most other US financial institutions
weren't following Jon Corzine's strategy of loading up on the debt of Italy, Spain and
Ireland.

It turns out that there are very good reasons banking is so homogenized. In the first
place, the capital regulations around the world incentivize banks to over-invest in
certain favorable asset classes. The rules for capital cushions encouraged banks to buy
mortgages and sovereign debt. In Europe, banks weren't required to have any capital
cushion at all for sovereign debt, which made government bonds very attractive.

Another factor driving homogenized banking is the potential for bailouts. Banks that
buy only what other banks are buying know that they won't fail unless other banks are
also failing, in which case central bankers and governments will intervene to prevent a
systemic crisis. Banks that strike out on their own are allowed to fail if their bets are
wrong.
Imagine, for example, if a dollar-eating microbe destroyed all the dollars in a single
bank's vault. The depositors would be insured and wouldn't lose any money. But the
bank itself would be out the money, unless it had private insurance for dollar-eating
microbes. The Fed probably wouldn't intervene to replace the lost dollars.

Now imagine that the same microbe destroyed the dollars in every bank vault in the
country. In that case, the Fed would intervene to replace the lost currency. When a
problem becomes systemic, regulators step in.

This pattern is built right into the law. Dodd-Frank prohibits the Fed from launching
emergency facilities for single institutions. If this law was in place in 2008, the Fed
probably couldn't have provided AIG with the emergency loan that kept the company
out of bankruptcy. The Fed is only allowed to open rescue funds if they are generally
available to all members of the banking system.

This means that "going it alone" is riskier for a bank’s management, as well as for its
creditors and shareholders. Everyone involved rationally rewards banks that follow
the pack with higher share prices and more attractive loans than are available to
individualist banks.

Ironically, it's this very pattern that creates systemic risk. When the strategy everyone
is following goes wrong, the system begins to collapse, and the entire banking herd
runs off the cliff together.

Is there a way out of this trap? Surprisingly, regulators may have stumbled upon it in
2008. Allowing Lehman Brothers to fail even though it wasn't really much worse off
than, say, Merrill Lynch, created the possibility that bond holders could lose money
even with banks that are part of the banking herd. This could have diminished the
benefits that members of the banking herd enjoyed.

The lesson was all the more powerful because of the seeming arbitrariness of letting
Lehman go while rescuing Merrill or Morgan Stanley. If the point is to take away the
benefits of being in the herd—and therefore discourage herd banking—you have to
cull almost at random.

Unfortunately, the experience of letting Lehman fail is so widely deemed as a disaster

that many are confident regulators will never again take that route. So the herd
mentality of banking is once again firmly in place.

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