The Structure of Confidence and the Collapse of Lehman Brothers

Introduction (Via Swedberg U Alberta & Cornell)

Despite its importance, there only exists a very small number of studies that look at the role of confidence in finance (e.g. Walters1992; for a review, see Swedberg forthcoming). In this paper I will draw on one of these, Walter Bagehot‟s classic work Lombard Street (1873). Bagehot is interesting in this context because he was well aware of the special role that confidence plays in the banking world. He also tried to explain the role that confidence plays in unleashing a financial panic, something that is of special relevance for this paper.
The banking system, Bagehot notes, always demands an extra high level of trust, much higher than elsewhere in the economy. In this particular part of the economy there has to exist, as he puts it, “[an] unprecedented trust between man and man” (Bagehot 1922 [1873]:151; emphasis added).
There are mainly two reasons for this, one having primarily to do with liquidity, the other with solvency. The first reason for the unprecedented level of trust to exist in the banking system has to do with maturity transformation – that deposits are short-term, while loans are long-term. If the depositors do not have full confidence that their money is safe, they will demand it back. And when they do so, the bank will be in trouble since it lacks liquid resources to pay back the depositors in full. The larger the amount that is

lent out, in relation to the amount deposited, the more tenuous this type of liquidity related type of confidence will also be.
The second reason for confidence being extra important in the banking system has to do with losses that the bank may occur through its loans. A bank is extra vulnerable, in other words, not only because of liquidity-related troubles, but also because of its losses, since these must be offset against the capital of the bank. Again, the more that has been lent out, the more vulnerable a bank is. And losses increase in their turn the leverage ratio dramatically.

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18. January 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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