In Part II, I’ll show how the Committee to Save the Banks discussion of the panic, fear and bank runs of 2008 confirms the Information Matrix explanation of where financial crises come from.

Douglas Diamond and Philip Dybvig’s  Bank Runs, Deposit Insurance and Liquidity has been hailed as the seminal paper on its title’s topic because of its influence on how both economists and policymakers think about and respond to bank runs.

However, their paper is fatally flawed.  In their paper, the authors describe the causes of a bank run as a “commonly observed random variable” and then give examples of what this variable might be.

This could happen if the selection between the bank run equilibrium and the good equilibrium depended on some commonly observed random variable in the economy. This could be a bad earnings report, a commonly observed run at some other bank, a negative government forecast, or even sunspots. It need not be anything fundamental about the bank’s condition.

Hmmm… I had to read their proposed causes of bank runs several times before it hit me.  The authors either didn’t realize banks are opaque or they didn’t understand the implication of this opacity.  In either case, opacity hides the fundamental condition of the banks and this makes all of their random variables potential triggers for a bank run.

Regular readers know it is the absence of information that makes bank runs possible.  When depositors/investors have the information about the bank’s fundamental condition, the facts stop them from engaging in runs.  When they don’t have this information, there are almost unlimited triggers for and nothing stopping a bank run.

Recall in Part I of this series, I described how the policymakers redesigned the financial system in the 1930s to “eliminate” banks runs.  Deposit insurance was adopted in 1933 to stop retail bank runs.

When the acute phase of the financial crisis hit in 2008, deposit insurance had not yet been extended to wholesale funding of the banks.  Why?  It was assumed in the redesign of the financial system investors who provided a bank with wholesale funding were capable of assessing for themselves or hiring a third party expert to assess for them the information disclosed on each bank’s fundamental condition.

While this assumption about the investors analytical capabilities was true.  It rested on another bigger assumption.  It assumed the government fulfilled its responsibility to provided transparency by requiring disclosure of the information needed so investors could assess the fundamental condition of each bank.  This assumption wasn’t true.

Wholesale bank funding, including unsecured bank debt, and bank equity securities are classic examples of securities in the Blind Betting quadrant of the Information Matrix.

Information Matrix

	Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying?		Yes	No
	Yes	Perfect Information	Antique Dealer Problem
	No	Lemon Problem	Blind Betting

These securities are sold based on a “story”.  In this case, the story is about the opaque bank’s fundamental condition.  Investors can Trust, but cannot Verify the “story”.  When the “story” is called into doubt, investors know to run and get their money back.  Why?  In the absence of information, there is no logical stopping point in the downward valuation of the opaque, Blind Betting quadrant securities other than zero. Hence, the incentive for investors to “run” to try to get as much of their money back as possible.

Now let’s look at how the Information Matrix’s description of “runs” from opaque securities fits the Committee to Save the Banks’ description of what happened in 2008.

The interviewer is Kai Ryssdal.  The members of the Committee to Save the Banks are Hank Paulson, Ben Bernanke and Tim Geithner.  It begins with Mr. Geithner effectively describing an earthquake along the opacity fault line in the global financial system where the valuations of all the securities in the Blind Betting quadrant are called into doubt.

Ryssdal: I want to ask you, Tim, something that you say in your book, that you had a history of working with economic crises. This is what you did in the Treasury your first go round. You say you know what a crisis and a panic smell like. What does a crisis smell like?

Geithner: It’s hard to describe that. In some ways, what it was really like in terms of the panic, but, you know, you could hear it in people’s voices when they talk to you. You know, if you talk to people in the financial system around the world at that time, people who were, you know, like in a relatively enviable position: strong, competent, smart, experienced people, you could hear in their voices for the first time in my lifetime a level of fear about the existential risk to the country, to the system, that I don’t know how to capture it beyond that.

You can imagine the fear these supposedly “strong, competent, smart, experienced people” felt when they realize the size of their firms’ exposure to opaque, Blind Betting quadrant securities.  Each of these individuals would have known their firms had more exposure to these securities than they could afford to lose.

Then, as if I had scripted the interview, Bernanke and then Paulson confirmed they knew they were facing an opacity driven crisis involving securities in the Blind Betting quadrant of the Information Matrix.

Bernanke: No, I was just going to say that, you know, a panic is an emotional state, but it’s also an observable thing, which is money running away. Nobody wants to lend money on a short-term basis. And in Bear Stearns’ case, their short-term borrowing, the short-term funding was just running, and it was clear that that if we didn’t arrest that situation, it was going to spread to other companies as well.

Please note how investors were running away from the opaque sectors of the financial system.  This includes both opaque financial institutions as well as opaque securities, like structured finance deals used as collateral for loans.

Ryssdal: I don’t want to get too deep into the nuts and bolts of this thing, but all three of you talk about the short-term lending market, repo and overnight and how critical all that was and how that just vaporized. And I wonder if we were set up by our very financial infrastructure to have this happen.

Paulson: Well, you’ve made the key point, which is, the key point is, we had a financial infrastructure that had been put in place years earlier, and then we’d had a financial system that had developed and really outgrown the regulatory authorities we needed to to manage it. We didn’t have the transparency you needed into the system. [emphasis added]

Please reread the the highlighted sentence in Paulson’s comment again.  You  can rest assured if the regulators didn’t have the transparency they needed into the financial system neither did the financial market participants.

And who is to blame for the financial system developing so there was a lack of transparency?  The government.  Recall in the 1930s policymakers made it the government’s responsibility to ensure disclosure of all the information investors need to know what they own.

Why did the government not fulfill its responsibility?  Wall Street captured the process by which disclosure requirements are set.  Once Wall Street captured the disclosure setting process, it was free to create opaque securities.  What we saw in 2008 with the earthquake along the opacity fault line was how successful Wall Street was in creating and selling these opaque securities.

The Transparency Label Initiative is needed to neutralize Wall Street’s control over the process by which disclosure requirements are set.  By using a label, the Initiative indicates whether or not the disclosure is adequate so an investor could know what they owned.  It is then up to the investor to decide how much, if any, of their portfolio they want exposed to blindly betting.

So the question became how is an earthquake along the opacity fault line in the global financial system suppose to be dealt with and how did the Committee to Save the Banks deal with it.  I’ll address this in Part III: Paulson the Puppet Master.