This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

We extend the Diamond and Dybvig model of bank runs by assuming that agents do not have common knowledge regarding the fundamentals of the economy, but rather receive slightly noisy signals. The new model has a unique equilibrium in which the fundamentals determine whether a bank run would occur. This lets us compute the probability of a bank run and relate it to the parameters of the demand deposit contract. We find that offering a higher return to agents demanding early withdrawal makes the bank more vulnerable to runs. Nonetheless, we show that even when this drawback is taken into account, demand deposit contracts still improve the welfare of agents.

We model systemic risk in an interbank market. Banks face liquidity needs as consumers are uncertain about where they need to consume. Interbank credit lines allow to cope with these liquidity shocks while reducing the cost of maintaining reserves. However, the interbank market exposes the system to a coordination failure (gridlock equilibrium) even if all banks are solvent. When one bank is insolvent, the stability of the banking system is a¤ected in various ways depending on the patterns of payments across locations. We investigate the ability of the banking industry to withstand the insolvency of one bank and whether the closure of one bank generates a chain reaction on the rest of the system. We analyze the coordinating role of the Central Bank in preventing payments systemic repercussions and we examine the justi…cation of the Too-big-to-fail-policy.

Banks are known to fail either because they are intrinsically insolvent or because an aggregate shortage of liquidity renders them insolvent. We show that the reverse can also happen: bank failures can shrink the common pool of liquidity, leading to a contagion of failures and a possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention. Our work suggests the conventional wisdom of helping only solvent but illiquid banks in a crisis has to be rethought. We are grateful to John Cochrane, Isabel Gödde, Nobu Kiyotaki, and three anonymous referees for very helpful comments on an earlier draft, and to Steve Ross and participants at the NBER Economic Fluctuations meetings in February 2001 for helpful suggestions. We are grateful for financial support from the National Science Foundation and the Center for Research on Security Prices. Rajan also thanks the Center for the Study of the State and the Economy for financial support. Many economists would agree that an important role of a central bank is to alleviate a

Robust (cross-border) interbank markets are important for the well functioning of modern financial systems. Yet, a network of interbank exposures may lead to domino effects following the event of an initial bank failure. The "structure" of the interbank market is a potential important driving factor in the risk and impact of interbank contagion. We investigate the evolution of contagion risk for the Belgian banking system over the period 1993-2002 using detailed information on aggregate interbank exposures of individual banks and on large bilateral interbank exposures. We find that a change from a complete structure (where all banks have symmetric links) towards a "multiple money centre" structure (where the money centres are symmetrically linked to some banks, which are themselves not linked together) as well as a more concentrated banking market have decreased the risk and impact of contagion. Moreover, an increase in the proportion of cross-border interbank assets has lowered the risk and impact of local contagion. Yet, this reduction was probably accompanied by an increase in contagion risk generated by foreign banks, although even here the contagion risk appears fairly limited.

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We explore the connection between money, banks, and aggregate credit. We start with a simple “real ” model without money, where banks make loans repayable in goods and depositors hold claims on the bank payable on demand in goods. Aggregate production may be delayed in the economy. If so, we show that the level of ongoing bank lending, and hence of aggregate future output, can decrease with increases in the real repayment due on deposits: ceteris paribus, the higher the amount due, the more likely there will be insufficient goods, given the delay, to pay depositors, and the more new lending has to be curtailed to make up the shortfall. Thus a temporary delay in production can be exacerbated by banks into a more permanent reduction of total output. A number of inefficiencies including bank failures can result if deposits turn out to be too high. We then introduce money in this model. We show that if demand deposits are repayable in money rather than in goods, banks can be hedged against production delays: under certain circumstances, the price level will rise with delays in production, reducing the real value of the deposits banks have to pay out. But demand deposits payable in money can expose the banks to new risks: the value of money can fluctuate for reasons other than delays in aggregate

In standard asset pricing theory, investors are assumed to invest directly in financial markets. The role of financial institutions is ignored. The focus in corporate finance is on agency problems. How do you ensure that managers act in shareholders’ interests? There is an inconsistency in assuming that when you give your money to a financial institution there is no agency problem but when you give it to a firm there is. It is argued both areas need to take proper account of the role of financial institutions and markets. Appropriate concepts for analyzing particular situations should be used. 1 DO FINANCIAL INSTITUTIONS MATTER? When I was an assistant professor my view on referees was that nine out of ten of them were complete idiots. They obviously had no idea what my papers were about or they wouldn’t have rejected them. Fortunately the remaining one out of ten was astute and sometimes would actually recommend a revise and resubmit. Over the years I learned where the problem lay and it was not with the referees. By the time I was an editor my opinion on referees had been reversed and I realized how much they could

One of the most feared events in banking is the cry of systemic risk. It matches the fear of a cry of fire in a crowded theater or other gatherings. But unlike "fire, " the term "systemic risk " is less clearly defined. Moreover, unlike fire fighters, who are rarely accused of sparking or spreading rather than extinguishing fires, bank regulators have at times been accused of, albeit unintentionally, contributing to rather than retarding systemic risk. This paper discusses the alternative definitions and sources of systemic risk, reviews briefly the historical evidence of systemic risk in banking, describes how financial markets have traditionally protected themselves from systemic risk, evaluates the regulations adopted by bank regulators to reduce both the probability of systemic risk and the damage caused by it if and when it may occur, and makes recommendations for efficiently curtailing systemic risk in banking. I Systemic Risk Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts. Thus, systemic risk in banking is evidenced by high correlation and clustering of bank failures in a country, a number of countries, or globally. Systemic risk may also

the lack of expertise • Just some questions and observations • (quick summary) Diamond‐Dybvig type 3‐ period model: investors “flight to quality”; banks “excess liquidity”; policy recommendation: central bank to adopt a “leaning against liquidity ” approachSome questions for discussion… • Did Greenspan adopt a “leaning against liquidity ” policy in 1987? After “internet bubble burst”? Greenspan creates the “housing bubble”? (Taylor 2009) • (Modeling qn): why 3‐period model? What if there are infinite horizons? Would a “leaning against liquidity ” lead to “bubble cycle”?