A new white paper posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation highlights that U.S. banks were unable to fulfill their role as systemic liquidity providers until the federal government stepped in. Nada Mora, Senior Economist at the Federal Reserve Bank of Kansas City, and Viral Acharya, Professor of Finance at NYU authored the blog, and argue “The mechanism whereby the banking system as a whole provides backup liquidity to the market by experiencing sustained deposit inflows broke down from the ABCP “freeze” starting August 9, 2007 (as documented in Acharya, Schnabl, and Suarez (2013)), until just before the Lehman failure on September 15, 2008.”

Depositors make deposits in banks in crises because of deposit insurance

History shows us that depositors make deposits in banks in crises because of deposit insurance. The authors of the blog point out that banks saw plenty of deposit inflows to meet the higher and synchronized drawdowns of funds during episodes of market stress such as late 1998 following the Russian default and LTCM hedge fund failure and the 2001 Enron accounting crisis (Gatev and Strahan (2006)).

Depositors think of banks as a safe haven due to deposit insurance, so deposits usually pick up in crisis times. In the financial crisis of 2007, however, the banking system was itself at the center of the financial crisis, and the general public was aware of the situation. Analysts and financial experts were raising questions about the solvency of the entire banking system, which was overexposed to trillions of dollars of toxic credit instruments.

Mora and Acharya also point out that as the solvency risk of a bank increases, it becomes more likely it will  seek to attract deposits by offering higher rates (ex. Washington Mutual during the crisis). Figure 1 makes it clear this was an industry-wide trend using weekly survey evidence of deposit rates offered by failed banks as measured by the difference from the rates of banks that did not fail, over a one year period prior to failure, for failures occurring during the 1997 to 2009 period.

Banks Liquidity Financial Crisis

2008 government intervention was key to bank deposit recovery in financial crisis

The blog advances the argument that the weakness in the deposit funding position of banks and the sharp turnaround after Lehman’s failure can be explained by investor perception of greater risk in bank deposits compared to other financial instruments with similar liquidity and payment services. Of note, as most deposits were over the deposit insurance limit, investors were looking to hold assets with more explicit government guarantees than bank debt.

Included among the financial instruments that were perceived to offer greater government backing were Federal Home Loan Bank discount notes and Treasury securities. The authors note that funding inflow into government funds was greater than that into “prime” funds starting in August 2007, and continued after Lehman’s failure and the Reserve Primary Fund’s “breaking the buck”. At that time, the Fed stepped in to further guarantee the depository system by increasing insurance limits from $100,000 to $250,000, as well as the full insurance of noninterest bearing accounts and other measures.

Mora and Acharya conclude: “Therefore, explicit government backing appears to have been the key factor explaining the aggregate funding shifts.”