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The mechanics of how big banks fail depends little on the cause of a crisis

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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.

“I illuminate the weaknesses in the design of market infrastructure and regulations. 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.”

The wide angle

As a financial economist at Stanford University, I was naturally led to this project. Among other topics, I study capital markets, risk management, derivatives, credit risk, bond markets, and over the counter markets. These topics turned out to be central to the story of the financial crisis and to the subject matter of this book.

Also, over many years, I have been discussing the behavior of financial markets with market participants and regulators. As the financial crisis of 2007-2009 unfolded, I began spending a much bigger fraction of my time in meetings or on phone calls on issues that had not been widely understood.

Some institutional features of our financial system that had seemed obscure before the crisis suddenly became central, and alarming. The topics of these discussions included the potential for new regulations and for improvements in the design of market infrastructure. I found myself on a steep learning curve. I became even more curious about the inner workings of various murkier parts of the financial system.

After the fall of Lehman Brothers, I joined the board of directors of Moody’s Corporation, a major credit rating agency. This was also an opportunity for me to learn more about financial markets, corporate governance, and regulation. For many years, I had acted as a consultant to financial institutions, hedge funds, and other pertinent players. As the crisis deepened, I was taking part in more and more conversations with market participants, regulators, legislators, and journalists, both formally and “on background.” Given my primary role as a researcher and teacher, it became obvious to me that I should summarize what I was learning in an accessible form.

Leading up to 2007, academics had contributed surprisingly little to an understanding of some of the weaknesses in our financial system that should have been addressed earlier. (Exceptions include some of my colleagues, such as Bob Shiller at Yale and Raghu Rajan at the University of Chicago.)

Today, financial economists are much more actively involved in communicating concerns about our financial system. For example, I am a member of the Squam Lake Group, consisting of roughly a dozen economists that have taken precisely this role. We recently published The Squam Lake Report, also by Princeton, which provides a broad set of analyses and policy recommendations. And we remain active on this front.

July 27, 2011

A close-up

The book’s story line carries, I hope, some dramatic interest. And it demands relatively little background knowledge. A reader whose curiosity is piqued will hopefully go further and cover the supporting concepts and institutional knowledge in the remaining chapters.

Start with the opening of Chapter 1. A few pages here take the reader through the death throes of a large bank that is an active intermediary in markets for securities, derivatives, and overnight borrowing. The bank is losing its battle to maintain liquidity. The bank’s shareholders and managers cannot be easily convinced to raise new capital. Its counterparties, clients, and creditors are deserting it, one after another. They are in an effective run, racing each other to extract the cash that remains at the failing bank. The bank supplies cash to them readily, at first, in an attempt to signal its strength. To do otherwise would only heighten fears and accelerate the run. In the end, however, our protagonist bank cannot turn its illiquid assets into cash quickly enough to survive.

This bank is a fictional but realistic composite of Bear Stearns, Lehman Brothers, and Morgan Stanley. Morgan Stanley did not ultimately fail. It had a viable business and substantial assets—but its dramatic loss of liquidity threatened its collapse in the days following the October-2008 failure of Leman Brothers. I believe that Morgan Stanley would have indeed failed but for the dramatic provision of liquidity to it by the Federal Reserve Bank of New York.

“My hope is that readers will take away a deeper understanding of the incentives at play in and around these firms, the core “plumbing” of the financial system, and some of the key points of fragility in its design.”


There are undoubtedly sources of future financial crises that experts do not even contemplate today.

But the failure mechanics I explain in this book do not depend on the cause of a financial crisis. These mechanics are relevant as soon as suspicions arise over the ability of a systemically important bank to sustain itself.

My hope is that readers will take away a deeper understanding of the incentives at play in and around these firms, the core “plumbing” of the financial system, and some of the key points of fragility in its design.

It is possible that some of those responsible for making important related regulatory or risk-management decisions could draw some helpful insights from this book. This was obviously one of my motives. Another goal was to transfer this knowledge to graduate students—at Stanford and other universities. Some of them will have pertinent leadership responsibilities in the future.

I also hope that some intellectually curious readers whose careers are not connected with financial markets, but are merely anxious to learn more about our financial system, will enjoy reading How Big Banks Fail.

© 2011 Darrell Duffie
Darrell Duffie How Big Banks Fail and What to Do about It Princeton University Press 112 pages, 5 1/2 x 8 3/4 inches ISBN- 978 0691148854
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Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business. He is a Fellow of the American Academy of Arts and Sciences and past President of the American Finance Association, and serves on the board of directors of Moody’s Corporation and on the Financial Advisory Roundtable of the Federal Reserve Bank of New York.

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July 27, 2011