Financial Markets & Institutions: Banks, Central Banks, Markets and Crises

On Thursday 9 March 2023, depositors began pulling money out of Silicon Valley Bank, a US bank with well over 85 percent of its deposits above the insured limit by its own December filings. The next morning California's regulator closed it and handed it to the FDIC. The bank had not lost money on risky loans. Its trouble was an old one: it had put depositors' money into long-dated government bonds, the bonds had lost value when interest rates rose (more than $15 billion of unrealised losses on securities it planned to hold to maturity at the end of 2022), and depositors, who could leave in an afternoon on a phone app, noticed.

That story contains the whole subject. A bank is a machine for turning short promises into long assets. A market is a place where such assets change hands, at a price that moves. A central bank is the institution that can create the money to bridge a gap between the two. A person who has studied this course reads a banking headline as a question: what was the balance sheet, who could demand money, and how quickly?

Not investment or legal advice. This explains how financial institutions and markets work. The banks, securities and borrowers in the examples are invented, and nothing here is a recommendation to buy, sell or borrow.

Banks: leverage and the run

A bank's balance sheet has loans and securities on the left and deposits and owners' equity on the right. Equity is what is left if every asset is sold at book value and every creditor paid. Because equity is a thin slice, a small percentage fall in assets is a large percentage fall in equity. This is leverage, and it cuts both ways. The loss that wipes a bank out is simply the capital ratio.

That is why regulation focuses on capital. The Basel III standards of the Basel Committee on Banking Supervision, published in 2010, ask for common equity of at least 4.5 percent of risk-weighted assets, a further 2.5 percent conservation buffer, and a leverage ratio of at least 3 percent of total exposure, with national variations and phase-in dates that differ by country.

Without JavaScript: with 8 percent equity (80) and a 5 percent loss (50), equity falls to 30, a drop of 62.5 percent. At 8 percent loss it is gone.

Leverage is only half the fragility. The other half is maturity transformation: deposits can be withdrawn at once while loans come back over years. Douglas Diamond and Philip Dybvig modelled this in 1983. Even a perfectly sound bank has a second equilibrium: if each depositor expects others to withdraw, it is rational to withdraw first, and the expectation fulfils itself. Diamond, Dybvig and Ben Bernanke shared the 2022 Nobel Memorial Prize in economics for work on banks and financial crises.

Without JavaScript: with 10 percent liquid assets and a 20 percent fire-sale discount, a 40 percent run is survived (equity falls from 80 to 5); a 50 percent run is not (a deficit of 20), so the last depositors would recover about 96 cents on the dollar. Last in line loses, so everyone wants to be first.

Look at what the toy shows. With a zero discount, even a total run is paid in full, because loans can be turned into cash at par. With a large discount, the bank is sound only as long as nobody tests it. The cure that most countries chose is deposit insurance, which removes the reason for small depositors to run. The US created the FDIC in 1933; today the limit is $250,000 per depositor per bank, the EU's is €100,000, the UK's £120,000 (raised from £85,000), Brazil's FGC R$250,000, Mexico's IPAB 400,000 UDIs, India's ₹5 lakh (raised in 2020) and Japan's ¥10 million. Insurance has a cost: it can encourage banks to take risk (moral hazard), which is why it comes with capital rules and supervision. In 2023, uninsured depositors were exactly the group that ran.

Markets: the price is where your order meets the book

A stock exchange does not set one price. It keeps a limit order book: a queue of offers to buy at or below stated prices (bids) and offers to sell at or above stated prices (asks). The highest bid and lowest ask are the best quotes, and the gap between them is the bid-ask spread. Harold Demsetz described the spread in 1968 as the price of immediacy: it pays the people who stand ready to trade when you want to. Those people are market makers; in modern exchanges most are automated firms, and the quoted depth they offer can vanish in a shock.

A market order says "buy now at whatever price." It takes the cheapest asks first, then the next, and so on. A large order walks up the book, and the average price you pay is worse than the best quote. That difference is slippage, and it is one of the main costs of trading. The same mechanics run from the New York Stock Exchange and Tokyo to B3 in São Paulo, the Mexican Bolsa and the National Stock Exchange of India.

Without JavaScript: the best bid is 99.98 and the best ask 100.02 (a spread of 0.04). Buying 1,000 shares takes 400 at 100.02 and 600 at 100.04, at an average of 100.032, or 3.2 basis points above the midpoint.

Whether the resulting price is "right" is the efficient-markets debate of Corporate Finance (34/51). Here the point is plumbing: liquidity, the ability to trade without moving the price, is a promise that is cheapest to keep when least needed.

Bonds and the yield curve: prices move against yields

A bond is a promise of fixed payments. Its price is the present value of those payments at the market yield, so when yields rise the price must fall. A 10-year bond paying 4 percent a year, priced at 100 when yields are 4 percent, is worth about 92.3 when yields are 5 percent: nobody pays 100 for 4 a year when new bonds pay 5. The longer the bond, the further its price swings, which is the idea of duration: roughly the percentage price change for a one-point move in yield.

Without JavaScript: at a 4 percent yield a 10-year bond is 100.00; at 5 percent it is 92.28, a fall of 7.7 percent. A 30-year bond falls from 100 to 84.63 (15.4 percent).

The yield curve plots yields against maturity. Normally it slopes up (lenders want paying for tying money up). A bank that borrows short and lends long earns the gap, so a flat or inverted curve (short yields above long) squeezes it, and rate rises hurt the value of what it already holds, as with Silicon Valley Bank. An inverted US curve (ten-year yield below the three-month) preceded every US recession since 1970 on the account compiled by the New York Fed, with leads of roughly six to seventeen months, and the signal is a probability and not a calendar. Whether the inversion that began in 2022 will fit the pattern is a question for the data to answer.

Central banks: the balance sheet that can expand

A central bank is a bank for banks. Its liabilities are currency and the reserves that commercial banks hold with it, and it can create more of both. Its assets are government bonds and loans to banks. Four jobs follow from that: set the policy rate (covered in Macroeconomics, 34/43), run the payment system, supervise banks, and act as lender of last resort. Walter Bagehot's rule, in Lombard Street (1873), was to lend freely, at a penalty rate, against good collateral, to sound banks in a panic. It protects the system, and critics note it also rescues those who took the risk.

Quantitative easing is the same balance sheet used to push down long yields once short rates are near zero. The Bank of Japan began it in March 2001; the Federal Reserve announced its first round in late 2008; the ECB began large-scale purchases in 2015. Supporters point to studies finding lower long-term rates and growth; critics worry about asset-price inflation, inequality and the dependence of governments on cheap financing. The idea is that the central bank buys bonds with newly created reserves.

Without JavaScript: in QE the central bank swaps reserves for a bank's bonds; the bank's total size is unchanged. In an emergency loan, the central bank's assets and its reserve liabilities both grow by the loan.

Mandates differ, and the differences matter in a crisis. The Federal Reserve has a dual mandate from Congress: maximum employment and stable prices. The European Central Bank's primary objective under the EU treaties is price stability, defined as 2 percent over the medium term. The Bank of England has a 2 percent target set by the government. The People's Bank of China answers to the State Council. Brazil's central bank pursues a 3 percent target with a 1.5-point tolerance set by the National Monetary Council, and gained formal autonomy by law in 2021. The Reserve Bank of India targets 4 percent with a 2-point band under its law since 2016.

Crises: one pattern, several explanations

Crises are not all alike, but they often follow a recognisable arc: credit grows, asset prices rise, lenders ease, a shock arrives, and a flight from risk exposes who owed what to whom. Economists agree that crises happen; they disagree about the cause. Here are three, with the main schools, told in their own best terms.

Crisis	Explanation	By whom
1929 to 1933	The Fed let the money stock fall by about a third, turning a recession into a depression	Milton Friedman and Anna Schwartz, A Monetary History of the United States (1963)
1929 to 1933	No country was willing to act as lender of last resort across borders after Britain could not and the US would not	Charles Kindleberger, The World in Depression (1973)
1929 to 1933	Falling prices raised the real weight of debt, forcing more selling: a debt-deflation spiral	Irving Fisher (1933)
1929 to 1933	An unsustainable credit boom of the 1920s had to be liquidated	Austrian school (Mises, Hayek)
2007 to 2009	Lenders and rating agencies mispriced mortgage securities; funding by short-term repo was a run on the shadow banking system after Lehman failed on 15 September 2008	Gary Gorton and Andrew Metrick; the US Financial Crisis Inquiry Commission (2011)
2007 to 2009	Capital from high-saving countries pushed US yields down and chased assets, or interest rates were held too low for too long	Ben Bernanke (the "savings glut"); John Taylor
March 2023	Interest-rate risk, concentrated uninsured deposits and a fast digital run; supervisors had seen the weakness and did not act in time	US Federal Reserve's own review (April 2023)

These are the main published accounts, summarised; each author said more than one line, and historians weigh them differently. 1997 and 1992 currency crises are in International Trade & Finance (34/47).

Hyman Minsky offered a lens that fits several of them. In Stabilizing an Unstable Economy (1986) he sorted borrowers into three kinds. Hedge units can pay both interest and principal from their income. Speculative units can pay interest, but must refinance the principal. Ponzi units cannot even pay interest from income and rely on rising asset prices. His claim was that long calm makes lenders and borrowers drift from the first kind toward the third, so stability breeds instability. It is not the consensus view (some economists find it hard to test), though after 2008 it was widely quoted.

Without JavaScript: at 5 percent and no shock, seven borrowers are hedge (income at least 15) and three speculative. At 10 percent, four are hedge, five speculative and one Ponzi.

Notice that no borrower here changed behaviour: the rate and incomes moved. That is the sense in which a rise in rates or fall in income converts safe loans to risky ones without any new decision, and why so many crises begin as a change in the price of money.

Other ways to lend: Islamic finance and microfinance

The same functions, saving, lending and sharing risk, are done in more than one way. Islamic finance follows the prohibition of riba (interest) and of excessive uncertainty. Its contracts include murabaha (the bank buys an asset and resells it to the customer at a disclosed mark-up, paid in instalments), mudaraba and musharaka (profit-and-loss-sharing partnerships), ijara (leasing) and sukuk (asset-backed certificates, the Islamic analogue of bonds). The Islamic Financial Services Board put Sharia-compliant assets at about US$3.9 trillion in 2024, with a broader ICD and LSEG definition giving about $6 trillion, concentrated in the Gulf states, Malaysia and Indonesia. Murabaha has become the most common form in practice. Scholars disagree about the whole structure: mainstream scholars hold that markup on a credit sale is permitted trade and interest on money is not, while critics argue that many contracts are conventional loans in legal form, and that the original ideal of profit-sharing is rarely used.

Microfinance lends small sums to poor borrowers, often women in groups. Muhammad Yunus began lending in the Bangladeshi village of Jobra in 1976, Grameen Bank became a formal bank in 1983, and he and the bank shared the Nobel Peace Prize in 2006. Enthusiasm was followed by evidence: a set of six randomised evaluations published in 2015 (in Bosnia and Herzegovina, Ethiopia, India, Mexico, Mongolia and Morocco) found that microcredit raised business activity modestly but did not, on average, transform household income or other measures of welfare. Critics also point to high rates and over-indebtedness, as in the Andhra Pradesh microfinance crisis in India in 2010 that led to a state ordinance and a later regulatory ceiling; supporters note that borrowers use it to smooth cash flow and that the poor have few alternatives, often moneylenders at far higher rates.

Both raise the same practical question: what is the price? Lenders quote it in different ways. The universal answer is to convert any contract to its internal rate of return, the rate that equates the sum borrowed with the instalments paid. A "flat" rate, charged on the original amount for the whole term, is much more expensive than the same number on a declining balance, because you keep repaying principal and yet pay interest on all of it.

Without JavaScript: 1,000 over 24 months at a 10 percent flat rate means a total of 1,200 and 50 a month, which works out to about 18.2 percent a year on the declining balance. The same 10 percent on a declining balance is 10 percent nominal.

This does not say a murabaha is the same thing as a loan: for many believers and scholars the legal and ethical difference is the point, and the contract also differs in what happens on default or early repayment. It says only that, in arithmetic, the price of money is comparable across them.

What a graduate just sees

• A bank is a leveraged bet on its assets: the capital ratio is the size of the loss it can take.
• Maturity transformation makes a sound bank vulnerable to a run, and a run is self-fulfilling.
• Deposit insurance, capital rules and a lender of last resort are three parts of one design.
• A market price is where an order meets a book; large orders walk the book and pay for it.
• Bond prices fall when yields rise, and the longer the bond, the more.
• A central bank's balance sheet can expand at will, which is power and risk at once.
• Crises have several authors' explanations; the honest summary is that credit, leverage and liquidity all matter.
• To compare any loan, convert it to a rate of return per year.

Where it shows up next

• Investments & Portfolio Theory (36/49): the yield curve, the spread and liquidity are the raw data behind expected return and risk.
• Derivatives & Risk Management (36/50): futures and swaps exist to move the interest-rate and currency risks that bank balance sheets carry.
• Business Law & Ethics (34/55): bank resolution, disclosure and the duties of directors when a firm is failing.
• Financial Statement Analysis & Valuation (36/52): reading a bank's statements differs from reading a factory's, because assets and liabilities are mostly financial.
• In the world: your deposit insurance limit, the rate on a mortgage, a margin call, a central bank's press conference, the story behind each financial headline.

If you want to go deeper

• 📘 Textbook. Frederic Mishkin, The Economics of Money, Banking, and Financial Markets (Pearson), the usual syllabus text; or Stephen Cecchetti and Kermit Schoenholtz, Money, Banking, and Financial Markets (McGraw Hill). Check for the current edition.
• 📘 Gentler. Charles Kindleberger and Robert Aliber, Manias, Panics, and Crashes (a classic history of financial crises), or Carmen Reinhart and Kenneth Rogoff, This Time Is Different (2009), eight centuries of crises with data. Read it knowing that one of their related empirical papers, on debt and growth, was publicly corrected in 2013.
• 🌐 Free course. Robert Shiller's Yale ECON 252, Financial Markets (Open Yale Courses, recorded Spring 2011), and MIT OpenCourseWare 15.401 Finance Theory I (Fall 2008).