Darrell Duffie

 

On his book How Big Banks Fail and What to Do about It

Cover Interview of July 27, 2011

In a nutshell

This book addresses precisely the questions raised by its title.

We all know that banks fail when they can’t pay their debts on time. This book spells out the specific steps by which it becomes impossible for a large and systemically important bank to continue to meet its obligations.

My particular focus are major global dealer banks, which make markets in securities, derivatives, and other wholesale assets, and run large asset management and brokerage businesses. Examples include Goldman Sachs, JP Morgan, Barclays, BNP Paribas, Bank of America, and Citibank. Those that effectively disappeared during the financial crisis are Bear Stearns, Lehman, and Merrill Lynch.

I begin from the point at which there are already suspicions about a dealer bank’s financial condition. As those concerns grow, an adverse series of actions by the bank and its creditors, shareholders, contractual counterparties, and clients is set in motion.

I explain this sequence of events in clinical detail, focusing particularly on the failure mechanics. I emphasize the incentives of the key players. Foremost are the run-on-the-bank incentives of short-term creditors. And foremost among them are money market mutual funds, which lend the banks money overnight, day after day, until they decide not to.

Critical short term funding is also provided by clearing agents, usually banks themselves, which give intra-day credit to dealer banks, collateralized by the dealer bank’s securities inventories. I show why a bank in trouble is likely to further weaken itself as part of a bluff of strength, supporting my account with explicit examples of behavior that occurred during the financial crisis.

I illuminate the weaknesses in the design of market infrastructure and regulations.  For example, the book exposes the key financial contracts, such as over-the-counter derivatives and repurchase agreements. I also cover the asset management and off-balance-sheet client relationships that figure prominently in the steps toward failure.  And I make specific proposals for how to remedy the weaknesses.

My goal is to use prose that is accessible to a relatively wide range of non-specialist readers—including those legislators or regulators who wish to come up to speed on the topic.

These readers tend to have significant demands on their time.  So the book is short and simple enough to be digested, say, during a train ride from New York to Washington DC.

I would rather leave some details to background literature, which I cite.  A technical appendix covers some of the details regarding the central clearing of derivatives, by which these contracts are effectively guaranteed by special-purpose financial utilities.

This seems to be the first book of its type.  Other authors have tackled weaknesses in our financial system.  But they have generally taken a “macro” viewpoint.  They have covered, among other topics, who was responsible for the recent financial crisis, and what were the larger economic forces leading to the morass of over-indebtedness and weak regulatory oversight in which we found ourselves.  Those issues are obviously important and interesting.

But I was drawn instead to an apparent gap in the literature. I saw the need for a synthesis and exposition of institutional mechanisms regarding big-bank failure.  These mechanisms are buried in relatively inaccessible primary-source documents.

Then I coupled this synthesis with an analysis of adverse incentives, key infrastructure weaknesses, and requirements for new approaches.  Throughout, I draw from well established micro-economic theories of bank runs, capital raising, markets with asymmetrically informed investors, and games with signaling incentives.