Economics in the Time of COVID-19
Banks are like black boxes: outside observers know little about the value of their assets,
especially in the aftermath of a shock such as a broad-based plunge in asset prices. As a
result, bad news can lead depositors to question the solvency of their bank.
Furthermore, banks are vulnerable. The sequential process of redeeming deposits at
face value creates a first-mover advantage: those who get to the bank first get paid in
full, while those who are patient (or just slow) may receive nothing. This leads to a run.
What is more, like viral illnesses, bank runs are contagious. The news about a run on
a specific bank alerts everyone to the fact that there may be other ‘lemons’ among
the universe of banks, turning a run in to a panic. Put differently, when people have
insufficient information, shocks can cause them to behave in ways that amplify rather
than dampen disturbances. Even if everyone believes that most banks are solvent,
uncertainty about this bank or that bank can be enough to motivate a run.^2
These similarities suggest that the means we use to control bank runs also may be useful
in managing the economic consequences of an emerging pandemic like COVID-19.
By lending against good collateral to solvent banks, a central bank can easily manage a
liquidity-driven run. But if banks’ solvency is in question, then the problem shifts to one
where authorities need to credibly demonstrate the health of the banks. Amid frozen
markets and fire sales, how can they do that?
In our experience, the most effective mechanism to arrest financial contagion driven
by solvency concerns is an extraordinary disclosure mechanism. Stress tests that aim
to reveal banks’ true condition are the most powerful such tool. In late 2008, doubts
about the capital adequacy of the largest US intermediaries made potential investors,
creditors, and customers wary of doing business with them, leading to a virtual collapse
of unsecured finance. The May 2009 publication of stress test results for the 19 largest
US banks constituted a key part of the remedy (Board of Governors of the Federal
Reserve System 2009).
Why did the US stress tests restore confidence? One reason is that they were serious: a
bank that passed the test could still lend to healthy borrowers despite a deep recession.
But people also had to believe that the disclosure was truthful. Wouldn’t policymakers
have an incentive to declare all banks healthy, even if some were not?
2 For slightly more detail, see our primer on bank runs (Cecchetti and Schoenholtz 2020).