Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

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Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

Banks (2) – Asset Transformation and Liquidity Creation. Banks’ Vulnerability with Respect to Runs

Week 3 of the Course is devoted to the analysis of creation of liquidity – namely, we do answer the question of how a bank attracts depositors. You will get introduced to asset transformation and will learn how the presence of banks in capital markets makes the money circulation in the economy more efficient. You will analyze the market participants’ preferences and the “safety cushion” of a bank. We will study the mechanism of bank runs and feel how vulnerable the bank is with respect to runs. You will learn what methods of fighting bank runs have been used in centuries, and realize why the role of government in regulating of the banking business is so important. We will discuss deposit insurance as a universal and effective mechanism of preventing runs.

3.1. How to induce depositors?4:19

3.2. Liquidity creation (1) – the model of liquidity11:27

3.3. Liquidity creation (2) – the mechanism10:16

3.4. Banks’ vulnerability with respect to runs15:56

3.5. Ways to fight bank runs (1) – suspension of convertibility4:46

3.6. Ways to fight bank runs (2) – deposit insurance9:03

3.7. Problems of deposit insurance12:00

3.8. Deposit insurance and the need to regulate6:04

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

In the previous episode,

we, in greater detail,

discussed the problem of a bank run and we said

that there are two major ways to fight against that.

Namely, the suspension of convertibility and deposit insurance.

In this short episode,

I would like to point out some other potential problems of

ways that are not dealing with insurance that occur in the world right now.

Let's go back to the case of suspension of convertibility for a moment.

We said that if

you said that you would not give the money to some of the people at point one,

said here, the 21st person comes,

and you say no.

Then, somehow that although is very inefficient,

that looks very much like a breach of contract that does provide a lot of problems

but it saves the bank from its bankruptcy at point two.

But all that, I said this is an approach that has worked for hundreds of years.

But now, imagine that anything like that happens right now,

when everyone is on Twitter and Facebook now.

How much time does it take for the depositors of the bank,

this 21st depositor to tell the crowd of people that there are problems at the bank?

How much time does it take for many of these people to withdraw the money automatically?

Because most of them use internet banking,

so they don't have to go to the bank.

They don't have to knock on the door.

They can just push the button and they're not

even their computer on their phone and then the bank will be doomed.

So we can see that although,

systemically, deposit insurance was introduced after the great depression in the 30s,

but now we cannot even think about lack of that because now,

the information is transmitted so quickly,

and of the power of the crowd is so great

that it will bury any bank that is not prepared to do that.

So, clearly, everything that has worked for a couple of

hundred years will be completely unthinkable these days.

Now, if we go back to the idea of deposit insurance,

there is one more thing that I would like to say right

now before talking about deposit insurance in greater detail.

It seems to be universal in great measure if whatever happens at point one,

someone says, I will support the bank.

If the bank fails to make a payment, I will.

Now, the question arises,

will this someone be able to make these payments in reality?

Remember when we talked about how the bank creates liquidity.

We fall through the scheme.

Remember this bank balance sheet,

acts of the drama and also how much money is left to the bank.

So where does this someone get money?

How come that this someone can take such a huge obligation

and that gives us a signal that this someone should be somewhat special?

In the next episode,

we'll talk about the mechanics of deposit insurance.

We will see why this someone is actually the government,

and we will also see that even if this is the government,

in the introduction of the first moves of deposit insurance,

there were a lot of questions.

Well, we know that when it was first introduced in United States in 1933,

well actually, United States was the second country to introduce deposit insurance.

The first was in Czechoslovakia,

just a couple of months before.

But, for now, what we can say is the people

who were discussing whether we should do that or should not do that,

it sounds very strange,

how come that someone could be against that?

Now, the problem is that,

if for any reason,

the government fails to make these payments,

then that's what these people stated,

that many years ago.

Then we could see a systemic collapse and we will lack instruments to overcome it.

Now with all that, we will discuss in

much greater detail in what follows in the next episode.