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Abstract
Financial services are an increasingly important sector in modern economies, yet many accounting and auditing texts focus on manufacturing and retailing. This teaching note describes the role of financial institutions in transforming long-term, difficult-to-sell assets into short-term bank accounts. This is referred to as liquidity transformation. The social benefits and risks of liquidity transformation are described. The social benefit occurs due to the increased liquidity provided by the bank to depositors. The risk comes in the form of a bank run, wherein difficult-to-sell assets cannot be redeemed in time to cover the rapid and unexpected withdrawals of depositors. The financial statements of a financial institution are presented and the issue of valuation is discussed. Finally, practical relevance for accounting students is enhanced by including discussions of historical precedents and of implications for financial reporting and auditing.
Acknowledgments
We thank participants at the 2011 American Accounting Association Public Interest Section Annual Meeting and the 2011 American Accounting Association Mid-Atlantic Regional Meeting for their helpful comments.
Notes
1. The growth of the financial services sector was criticized both before and after the financial crisis (Johnson and Kwak, Citation2010; Phillips, Citation2006). One prominent economist went so far as to call for radical re-structuring of the sector, specifically due to its practice of borrowing short and lending long, i.e. liquidity transformation (Kotlikoff, Citation2010).
2. For example, when a bank uses customer deposits to make a loan, they are principal to that transaction. In contrast, a real estate agent helps bring together buyers and sellers, but does not take possession of the property (i.e. never becomes a principal).
3. See Bernanke (Citation1983) and Diamond (Citation1984) for the role of monitoring and screening in financial intermediation.
4. The historical accounts are primarily drawn from the following sources: Bruner and Carr (Citation2007; Trust Company of America), McCollom (Citation1987; Continental of Illinois) and McLean and Nocera (Citation2010; AIG).
5. A short corner is a tactic where a speculator tries to gather all the outstanding stock in a company and force short sellers to buy back stock from him or her.
6. In the end the panic only subsided with the forced merger of two steel companies and an emergency waiver of anti-trust laws from President Theodore Roosevelt.
7. Our illustrations borrow heavily from Diamond (Citation2007) whose simplification of Diamond and Dybvig (Citation1983) we modify and extend for our purposes.
8. See Shleifer and Vishny (Citation2010) for an accessible discussion of illiquid assets and fire-sale prices.
9. Unrealistically small numbers are used for cash consequences, to keep the calculations in this note simple.
10. We here and henceforth suppress dollar signs.
11. In effect, the bank possesses no advantages over its depositors in the form of diversification opportunities or economies of scale. It has access to the same securities to which its depositors have access.
12. A subsequent section explores the possibility that the actual number of early redeemers might exceed that planned by the bank.
13. An analytical (as opposed to numerical) solution can be found by recognizing constraint (2) is tight, which implies r 2 = 2.5−0.5 r 1. Substituting into the objective function and taking the derivative with respect to r 1 provides r 1 = 200/(40 + 80(2.01/3)) ≈ 1.42, and hence r 2 ≈ 1.79. Students can solve the problem analytically as described above, or by using spreadsheet software capable of performing constrained optimization. Note this solution slightly improves upon that proposed immediately above of r 1 = 1.25 and r 2 = 1.875, wherein the expected utility is −0.1778 < −0.1744.
14. Although there are only two equilibria, = 20% or
= 100%, it is entirely possible that depositors, without a coordinating mechanism, will not coordinate to either one.
15. This is more or less the procedure for redemptions from hedge funds, which are notorious for holding high-yield illiquid assets (Ang and Bollen, Citation2010).
16. Repo loans are overnight loans between institutions or between an institution and the Federal Reserve. The loans are typically collateralized by securities.
17. A scene in the movie Mary Poppins provides a useful, if whimsical, illustration of a spontaneous bank run closing an otherwise healthy bank. When asked to present the material related to this note in class, several times our students have discovered and shown this scene to the rest of the class.