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Discuss about the Essay for "Toward a Run - Free Financial System".

This report is based on the research made by John C. Cochrane on the title ‘Towards a Run free financial System.’ In this report I am going to discuss the research and analysis made by John C. Cochrane who presented his strong views on a Run free financial system. He has defined financial crisis as a systematic run and the central regulatory system should be able to remove the run prone security from the financial system. He has strongly condemned the current the current regulatory structure by addressing it as hopeless. As per his opinion it is very simple to eliminate the runs and crisis which can be done with the rule based and simple liability regulations. He has also emphasised on the use of modern computational and financial technologies which can overcome the narrow banking.

Through his research, he has suggested the application of Pigouvian taxes which offers a better structure for controlling the debt issues as compared to the capital ratios. He further added that the financial institutions should be 100% funded by the equity so that in the case of debt or run the investors or a financial institution does not face run or crisis. In this report I am going to discuss run, run prone assets, stopping runs, policies to handle the financial crisis and recommendations will be made as per the feasibility of the solution.

John C. Cochrane in his work acknowledged one of the culprits of Financial Crisis occured in year 2008, which was the “influential shadow” banking system and did not rely on the bank deposits. Also he proposed a tax on the issue of any risky short-term debt (Havemann, 2009).  Cochrane admitted that his proposed system would not have been possible in the 1930’s- but with the latest technology, the customer can make the financial transactions by using profit from the money markets and exchange the traded funds without relying on the liquidity of a bank.  Under the proposed banking system of Cochrane’s, the banks would still be allowed to arbitrate the financial transactions and act as broker-dealers or custodians customarily.

He defined, Financial crisis as a situation in which the value of financial assets and institutions fall down rapidly. Such situation of financial crisis arises due to run on the banks or chaotic situations in which the investors withdraws their saving accounts and sell off their financial assets with the perception that their price may fall down if associated with the financial institutions .  The author conducted a research to propose a run free financial system for which he analyzed the shadow banking run, systematic run, causes for a run, how a run can be avoided, how a run can be stopped and what are the real effects of the run.

It seems that implying the Runs and Run Prone Assets policy is a good idea. It basically reflects a situation of fractional reserve, where the banking system holds a large number of customers withdrawing their saving bank accounts and financial assets from a financial institution which they expect may face a financial crisis or become insolvent in the future is termed as “Run”. John C. Cochrane in his work presented the views on Run, characteristics of run prone security and run prone contracts, such as Demand deposit.  The short maturity promises for a fixed value does not come under a run prone contract. He stated that if a financial institution is able to meet the demand of the creditors by selling his assets, the run cannot be developed (Cochrane, 2014).  It seems to be certainly right that the chances of bankruptcy are less when the 95% of the finance to the institution is provided by the Equity which states that Run needs a large amount of fund is provided by the run prone security.

Stock Again

The crisis may show real and strong effects, when the whole financial status of an economy is disturbed. There are two factors which hold a large macroeconomic effect and may be the possible reason for financial crisis i.e., Financial constraints and Aggregate demand. As per his point of view, financial constraints may create the gap which makes a healthy economy starved of the appropriate funds.

I believe that the revenue when earned should be recorded that very time. Because, it is not so essential to collect the revenue initially and then record it further. Also, it is not important to receive the revenue to record it in the books. The revenue is entered into the books of accounts either when it is realized or realizable. When the products are sold the revenue becomes realizable and it can be entered into books and it is not important to let the transaction fully take place. But when the sale is made, it is significant to note that the ownership should be transferred first and then revenue becomes realizable, only then it is recorded in the journals.

There are different rules of different entities, for example, some entity record the revenue during the production stage, some recognize it after production stage and before the sale is actually made. But some entities only record it when they get the cash and only after that the final statements are recorded (Cowen, 2014).

John suggested a solution for handling systematic runs in which he proposed a solution that the financial institutions should be funded by the Equity as Common Equity is immune from the run as per his opinion in terms of stock again. Another example of run proof intermediary is an exchange traded fund (ETF) which means funds cannot go bankrupt when the value of assets falls.

It is to be noted that the transactions which can be expressed in monetary form shall be recorded and communicated. The issues which cannot be expressed in monetary units or the transactions, there are other methods for their expression, but financial areas are covered by the accounting system and which can be mentioned in form of currency. One important thing of this assumption is that due to inflation, the purchasing power of the currency is lost with time but here in recording the statements in accounts’ books we move with the presumption that unit of currency is stable in value. It is also known as stable dollar presumption. But when there are cases of hyperinflation, this strategy doesn’t work and figures are required to be changed or adjusted. These kinds of situations come less often.

For Example: The plant and machinery of the company in 2010 balance sheet were to $10 billion. In 2011, the inflation rate was 15%. Due to this monetary unit assumption there was no adjustment made in the prior or current figures.

The entire discussion of the author has been evolved around the analysis of runs and crisis and how they could be stopped; another important issue which has been discussed by the author is raising the bank capital. There are a number of steps suggested by the author which can help the bank to increase its capital which has been listed below:

  • The first step is to eliminate the distortion sponsored debts mainly the short term debts. It is important that debts should be subsidized and its use should be condemned.
  • The next target is dividends versus tax deductibility of the interest payment.
  • The money market funds such as intermediaries are required to hold the debt for the short term as it carries the lowest risk weight for the bank (The World Bank Group, 2014).
  • An increase in the demand for the run prone assets encourages the supply by intermediaries which may result in the financial crisis which needs to be controlled.

Capital Regulation

It is very important for a company or any other entity to give full disclosure of its statements to the creditors or the public at large to make them know the true financial position of the entity. It is important because it helps the public to take decisions and invest in the company or entity. This helps to disclose all the relevant reports and statements. These statements depict a clear picture of all the accounting policies of the entity and the records of the revenues as well as details about the property that is how it is depreciated and information regarding other items for example income taxes, dividends, inventory etc.

The creditors take decision of providing credit to the entity only on the basis of the financial statements of the entity. It is important for the entity to record true information and provide to the public a true picture of the entity and no window dressing should be done. There should not be any fraud by the entity on the creditors, investors or public. The judgment of the people is based on these records and on the basis of this information the investors enter long term projects with the entity. So full disclosure of all the information is very imperative and useful as well

For Example, A company named Paul Real Estate, purchased one acre of property and after two years a man accidently slipped on that piece of property and met with many injuries. The man sued the company for negligence and the suit continues for three years. It is important for the company to disclose this in the statements. 

A comparative analysis has been made by the author of his views on the run free financial system with the views of Dodd Frank on the same. He has summarized his opinions related to the financial crisis and the reasons that may cause a run in the financial institution and how it can be avoided. John identified the systematic run as the reason for the financial crisis, but Dodd Frank, was unable to actually find the root cause of the run or crisis in a financial institution.

It seems that he did not define, any specific reason due to which financial system fails (Caballero & Farhi, 2016). Moreover, he did a very less work in order to improve the financial situation. He just focussed on the dangerous institutions which may probably affect the economy of the country. It should be noted that the resolution and macro prudential policies which are proposed by Dodd Frank just focussed on fire fighting and provided tools for managing the crisis. But, on the other hand, John work was only based on carrying out the detailed analysis of the cause of the problem, how it can be avoided, stopped and what measures could be taken to handle the financial system to make it run free. So, the other issues have been missed out and thus, the causes for that needs to be assessed and corrective actions should be taken accordingly.

Witnessing the economic conditions, it is vital to propose the regulations to fix the bankruptcy for which a systematic banking system is required which should be backed up by the equity. Moreover the loss of a financial system should be handled in such a way that it does not affect the investors’ personal stakes, business and the country’s economy (Team, 2016). 

There have been a number of proposals given by some authors (French et.al, Hart & Zingales) which suggest that the debts under some circumstances can be converted into equity. John in his work has presented a basic difference amongst the financing a large portion of bank assets and short term promises in market making, matched book, loan generation and other bank activities. It is important to detect the hidden run prone financing through regulations and it is easy to track in comparison to capital regulation, current asset regulation and stress testing.

I believe that the activities related to business which are to be entered in the books of accounts will remain separate from the personal activities of the owner. It provides that the separate records should be maintained of the accounts of the business as well as bank accounts should also be separately maintained. There should not be intermixing of the assets of the owner with the assets of the entity and same goes with the liabilities. The transactions of the business should be related to the entity and not to the owner. The entity can be partnership, governmental agencies; sole proprietors etc. The transactions of the business should always be considered important over the personal transactions of the owner or owners.

It is originated that a separate record should be maintained on a daily basis to avoid any confusion and these records are very essential for the future references and are considered to be important documents for the goodwill of the entity. So, it is very important to effectively set up these records.

For Example: Mr. Gopal, a partner in The Times Square, pays off the price of his personal items through the credit card of the company. He says that these are not personal expenses, but is business expenditure because he should wear good new clothes to look good for the clients. But this is not a business, but a personal expense and cannot be recorded in accounts’ books.

Run and crisis have been a part of the financial system, but it needs to be managed so that it does not affect the country’s economic stability.  A set of rules and regulations needs to be proposed that will manage the situation in case there is the probability of crisis and runs. As discussed above the flaws in the existing system is responsible for the financial crisis that a country had faced, there is a need to form new policies with the help of modern communication and computing technologies (Mathiason, 2008).

The information which is important for financial statement should be definitely recorded, because it will decrease the flaws of the system. When the information is important for the company, it automatically becomes important for those who would like to invest in the company or for the creditors who would like to give credit to the company. This varies from entity to entity. The information which is relevant for one entity may not be relevant to the other entity. Sometimes, a piece of information which is material for short scale information may not be important for a large scale enterprise.

The expert personnel are appointed to judge whether the information is relevant or not. The relevancy of information may be judged on various attributes and the quality of information matters and not the quantity of information. This information is important for those who are interested in entity and the users study every detail of these statements so these statements should be properly and systematically maintained.

The details as to how the events which h are uncertain are to be recorded.  It was suggested that the records should be maintained by recording the minimum to  minimum profits and not exaggerating it and it is to be done by making records of losses or the  expenditure which is uncertain and not the uncertain gains. Overestimation of the records, provide a wrong picture of the company to the persons who are interested in investing in the company or who wish to deal with the company.

The minimum profits and maximum profits should be recorded as this provides true information to the users and does not promote the window dressing. It means that, it is safe to record the revenues when they are actually earned and till then the minimum amount should be recorded.

John C. Cochrane has also emphasized on the run free financial system which means protecting an economy or a financial system from the crisis and run. He has suggested the best solutions through run can be avoided and stopped as well, which have been discussed below (The George Washington University Law School, 2014).

It is evident that Run affects the financial institution as well as the country’s economy, which are an identifying feature mentioned in some contracts being issued by the intermediaries. When the reason for run lies in the contract it is better to fix them with some regulations and use of run prone contracts should be strongly discouraged. As per his opinion, the commercial banks should be financed by equity, which will help their institution to be protected against the run and crisis. With equity the investor claim will float freely and they will have no claim on the financial institutions which will protect the institution from bankruptcy.

Pigouvain Tax, as a strategic effluent fee is evaluated against the business and private individuals to be engaged in the specific activity. This type of tax is generally used to discourage the activities which impose a net cost of manufacture on third parties which is called as a negative externality. John has favored the implementation of these taxes, as it is better than quantity controls in a number of areas of regulations and will also dispel the critics who lead the economic requirement of short term debt financing. Also, the demand for safe and liquid investment made by the investors is satisfied by the short term debt. Such debts are supplied by the financial sector by holding the positions in risky assets such as securities and loans which are funded by the short term debts. The author has investigated the need for fixed value assets, liquid, money and money, such as securities when the people these days are already using the modern technology for sale and purchase.

After an analysis of the research made by the John C. Cochrane I totally agree that the insolvency is the main focus of our attention. Modern banks are over-selling the safe asset, and the bank accounts need to be structured in a better way so that there is less risk of insolvency. Now, another problem of them being too correlated to fail – a financial downturn affects the system as a whole, which leads to bailout and crises. There are certain recommendations that have been made to make a financial system run free which is discussed below:

  • If the banks are insured against the macroeconomic risks, bank problems will be less correlated and there will be a less moral hazard.
  • The regulations related to the financial system should be altered after a period of time.
  • The use of modern communication and financial technology should be promoted to make the banking free from the run. The financial institution should be funded by equity which will help them to get a protection from the run.
  • The intermediaries’ contract which is prone to run should be avoided and their use should be strongly condemned.
  • Innovation in the financial institution is required to handle the issues in an effective and efficient way. Certain measures should be taken against all the processes carried in a financial institution.
  • Development of prudent monetary and fiscal policies, better regulation of the financial sector, which includes the reduction of the problem of too-big-to-fail the banks, and development of effective macro-prudential policies is required.
  • Despite the new regulations and good supervision, crises are probable to recur, in part as they can reflect the deep problems which are related to the political economy and income inequality, and human behaviour.
  • One of the most natural objections which are expected from a bank is to convert the maturity and risk, create liquidity, lend long and risk and borrow short and safe. This is one of the most important functions which must certify that the safety of the assets of the people. Though, maturity and credit risk cannot be removed completely, but it can be altered and modified suiting to the demands of the customer. So, investing in such function should be avoided.
  • The Safe assets have been utilized as a trustworthy store of value which also aids the capital preservation in the construction of a portfolio. I think that it is being a key element in the discreet regulation and safe assets would probably help the banks in providing the mechanism for improving the liquidity and capital buffers. As a point of reference, the safe asset certainly extends the support for the pricing of other risky assets. Ultimately, the safe assets are considered as a critical element in the operation of the monetary policy. (Gorton & Ordonez, 2013).

As per the whole assessment, implying the capital regulations and implementation of Pigouvian taxes, is better than maintaining quantity controls in a number of areas of regulations. From his point of view as well, this will probably dispel the critics who lead the economic requirement of the short-term debt financing. Then, there are certain objections which have been discussed, including demand and supply of the safest assets, credit supply and fixation of bankruptcy.  I believe that all the above mentioned points can assist in developing economy free from the run and financial crisis.

Conclusion

This report is based on the research and analysis made by Professor John C. Cochrane on run free financial system. In his research work he has conducted a detailed analysis of the financial system, causes for a run and financial crisis, how the run and crisis can be avoided and tackled, and the real effects of a run, analyzed the current policy and objections and made a comparative analysis. A run free financial system has been viewed in the context of financial technology and modern communication. An analysis has been made on the objections which includes the demand and supply of safe assets which is a preventive measure taken by the investors, credit supply to ensure the investors with safe assets and possible methods have been suggested to control a bankruptcy. Further the current policy with rules and regulations have been examined to ensure the run free financial system which includes the deposit guarantees, innovation in the financial system, being competitive in the market and make the market more fragile. The analysis made by Prof. John C. Cochrane which has been critically analyzed with the necessary recommendations that ensure the financial system free from run and crisis.

References

Caballero, R. & Farhi, E., 2016. Safe Asset Scarcity and Aggregate Demand, Available at: https://economics.mit.edu/files/11333

Cochrane, J., 2014. Toward a run-free financial system: University of Chicago Booth School of Business, Available at: https://faculty.chicagobooth.edu/john.cochrane/research/papers/run_free.pdf

Compliance Alliance, 2016. Federal Banking Regulations: Up-to-Date Bank Regulation Tools. [Online]
Available at: https://www.compliancealliance.com/laws-regulations/federal-bank-regulations

Cowen, T., 2014. John Cochrane on taxing debt, or toward a run-free financial system, Available at: https://marginalrevolution.com/marginalrevolution/2014/04/john-cochrane-on-taxing-debt-or-toward-a-run-free-financial-system.html

Gorton, G. & Ordonez, G., 2013. The Supply and Demand for Safe Assets: Yale University and NBER, Available at: https://www.sas.upenn.edu/~ordonez/pdfs/SDSA.pdf

Havemann, J., 2009. The Financial Crisis of 2008: Year In Review 2008, Available at: https://www.britannica.com/topic/Financial-Crisis-of-2008-The-1484264

Kodres, L., 2013. What Is Shadow Banking?. 50(2), Available at: https://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm

Limited, T. E. N., 2014. Narrow-minded: A radical proposal for making finance safer resurfaces, Available at: https://www.economist.com/news/finance-and-economics/21603431-radical-proposal-making-finance-safer-resurfaces-narrow-minded

Mathiason, N., 2008. Markets credit crunch banking 2008. Three weeks that changed the world, Available at: https://www.theguardian.com/business/2008/dec/28/markets-credit-crunch-banking-2008

Pleticha, P., 2016. Nowhere to run: designing a run-free financial system, Available at: https://smalltalkeconomics.com/?p=145

Team, P., 2016. The financial crisis happened because banks were able to create too much money, too quickly, and used it to push up house prices and speculate on financial markets, Available at: https://positivemoney.org/issues/recessions-crisis/

The Economist, 2016. How shadow banking works, Available at: https://www.economist.com/blogs/economist-explains/2016/02/economist-explains-0

The George Washington University Law School, 2014. Toward A Run-Free Financial System, Available at: https://www.gwsba.com/org/fleaf/toward-a-run-free-financial-system/

The World Bank Group, 2014. Can We Prevent Financial Crises?, Available at: https://www.worldbank.org/en/news/feature/2014/02/26/can-we-prevent-financial-crises

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