The Current Financial Crisis, Other Recent Crises, and the Role of Short-term Debt
Myron Scholes Global Markets Forum
October 28, 2008
In a crucial way, financial crises are basically all the same: they are “everywhere and always due to problems of short-term debt,” said Douglas Diamond. An expert on financial intermediation and liquidity, Diamond went on to explain the role of short-term debt in the banking system and how that role relates to the origins—and potential solutions—of the current crisis.
A key to understanding crises like the current one, he argued, was focusing on “the strategic role of short-term debt.” This is the role that short-term debt plays in imposing discipline on a financial firm that gets close to its borrowing limits. “When you’re using the last little bit of your debt capacity, when you’re trying to borrow close to 100 percent of the amount anybody will lend to you…that last little bit has to be short-term debt,” said Diamond. “Short-term debt keeps the borrower on the straight and narrow more than anything else because the lender can always say ‘No, I want my money back tomorrow.’”
This strategic use of short-term debt is crucial in disciplining financial firms, said Diamond, but the obvious downside is that it can lead to a run when losses leave a bank low on capital, thus prompting its short-term lenders to worry about its solvency. If assets are illiquid, “fear of losses can cause runs and fear of runs can cause losses,” said Diamond. It also means that in some circumstances, when everyone knows that banks will have to dump assets quickly to avoid a run, the mere anticipation of lower prices in the near future can keep liquid potential buyers on the sidelines and waiting for the cheap “fire-sale” prices instead of coming in sooner to buy assets and stabilize the situation. “That’s a form of contagion, and it’s a form of contagion that’s going on this week,” Diamond said, as the crisis grew in October 2008.
To stem financial crises like this one, said Diamond, it is essential to understand the nature of the short-term debt that’s involved and then to “find the first-come, first-serve element that gives people an incentive to rush for the exits” in the case at hand.