A more modern phrase for the contract structure I have discussed, involving diversification of assets and the issuance of debt claims to investors, is pooling and tranching. Pooling is just another name for diversification: make a bunch of loans and put them together in a pool from which to pay claims to investors. Tranching refers to giving investors senior claims and having the banker retain some junior claims to finance bonuses. This structure resolves many conflicts of interest in addition to those involving monitoring. Stanford’s Peter DeMarzo has a nice 2005 paper on this, “The Pooling and Tranching of Securities: A Model of Informed Intermediation.”
As I mentioned before, the pooling part doesn’t work perfectly, particularly when there’s increased correlation across returns of the assets. We saw this in the housing crisis of 2008–09: When house prices went down worldwide and in the US in particular, all of a sudden, the correlation between mortgage defaults, whether on subprime or other kinds of loans, increased dramatically. The diversification effect from pooling almost disappeared, and we saw senior mortgage-backed securities become, unexpectedly, much riskier.
The self-fulfilling prophecy
Pooling and tranching is one important financial contracting technology. A second one is in a paper, “Bank Runs, Deposit Insurance, and Liquidity,” that I wrote with Washington University’s Philip H. Dybvig. It again explains why banks and intermediaries are good to have in the middle, and why they use certain financial contracts. The financial contract we have in mind here is short-term debt. Why do banks use so much short-term debt to finance long-term illiquid assets, which leaves them subject to bank runs? Why choose to write contracts that leave you subject to runs if runs are so bad?
If you hold assets through a bank, you are better off than if you hold the bank’s assets yourself. Dybvig and I assume that the bank’s assets are long term and safe if you hold them to maturity, but illiquid. We show why the liabilities, deposits of this bank, should be short-term debt and liquid.
We take solvency off the table as a reason for bank failures, and that’s not because it’s off the table in practice. We assume that everybody knows that if you hold the long-term assets to maturity, the bank will be solvent. Because insolvency is not the reason for a run, we can see that bank failures can be caused by potential runs.
Bank deposits are more liquid than the loans they hold. This means if you hold a bank deposit, you get a higher return for holding it for one period and then getting rid of it quickly versus holding the underlying bank loan yourself for the same amount of time. Bank deposits then provide some insurance against needing to get out fast. That’s the first part of our model.
We also demonstrate that banks should do this because investors like liquid assets better than illiquid assets. That’s due to the fact that investors don’t know how long they’re going to want to hold those assets. They might hold them for one period, or they might not need them right away so hold them for two periods. There’s an important liquidity risk left: even though these assets are safe, you as a borrower face the risk that you might need to get out early. Liquidity is a form of insurance against this early need for funds.
Here’s a super-simple illustration of our model: There’s an illiquid but safe asset that you or the bank could invest in. If you directly invest €1 in this asset at date zero, you can hold it for either two periods and get €2 out, or one period and get your €1. If you hold this asset to maturity, you double your money, and if you get out of it early, you destroy half of that value. There’s a big loss if you get out in a hurry.
Suppose that the bank is going to issue more-liquid, short-term deposit claims backed by this illiquid, safe asset. The bank deposit is going to offer you a choice between €1.28 at date one or €1.81 at date two. The key thing is that if you hold the illiquid asset directly, you only get €1 at date one, whereas if you hold the bank deposit, you get €1.28. What’s important in this example is that 1.28 is a number bigger than 1. All these things that I am about to say are true for any number bigger than one.
This is creating liquidity because you’re giving people a bigger return over the short horizon. It’s not free for the depositor, who has to give up something over the long horizon, but it is a form of insurance against the need for liquidity.
Suppose there are 100 investors in the world and that we know for sure 25 of them will need their money on date one (call them early investors) and the remaining 75 will need their money on date two (call them late investors). We know the proportion will be 25 and 75, but what we don’t know yet is who’s going to need their money early and who’s going to need it later. There’s uncertainty about when you’re going to need your funding. You’d like to buy insurance against this uncertainty, and that’s what the deposits do in this setup.
Suppose that there’s not going to be a bank run and that the only people who pull their money out of the bank on date one are the 25 early investors who actually need their money then. In this case, we give 25 people €1.28, and we have to liquidate 32 assets to do so. That’s going to leave just enough assets (or actually a few extra assets because I did some rounding) to pay €1.81 to the people who leave their money in until date two. If everybody is clear on this point, there’s not going to be a run on this bank. The bank can create more-liquid deposits out of less-liquid assets. We can actually create liquidity here, which is good. If everyone forecasts that 25 will withdraw, this is a self-fulfilling prophecy.