Friday, 11 November 2011

A Tale of Two Models

Students always complain about how difficult it is to find the link between reality and basic economic principles, eventually avoiding the discipline completely. The dismal science is often given much less credit than it is due, with many critical policy decisions driven by basic models.

Today, the question is posed, why are there capital adequacy ratios, and why does the FDIC exist? While it is trivial that those rules are present to mitigate risk and to regulate bank activities, there are two economic models that go into proving this rigorously on both sides of the equation. This is the Kareken-Wallace model, and the Diamond-Dybvig model.

The Diamond-Dybvig Model was published by Douglas Diamond and Philip Dybvig in 1983 to address the issues that financial institutions faced with economic analysis. As a first step, it proved that the presence of banks themselves added a welfare benefit to the world by mitigating the risks of liquidity. To think about this concept, note that an individual might have a need for immediate cash, but as a group the possibility of everyone simultaneously having the need is low. The bank allows the pooling of these individuals and the lending out of their money. However it should be noted that as custodian of the group’s money, it is also susceptible to the herd mentality during financial crises. To prevent extremely destructive bank runs, the model postulated the creation of government deposit insurance, which would counter the sense of panic and convince depositors to leave their money in the banks even in the most turbulent of times.

The anti-thesis to the above model is the Kareken-Wallace model, published by John Kareken and Neil Wallace a couple of years before. This model shows that fundamentally, for a bank to have any profits, it needs to take some risk. For this risk to be taken, depositors will only put their money in the bank if deposit insurance is present. However this in turn gives rise to a serious moral hazard, in which the bank is in fact incentivized to take maximal risk for maximal return. In the worst-case scenario, the taxpayer will have to bear the burden of the losses. This model is therefore one reason why capital adequacy ratios and regulations are present, to prevent financial institutions from taking too much risk.

In academia today, many professors subscribe to either one of the models. Can you guess what model the Federal Reserve subscribes to?

- Leong

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