Run on funds drives LDC finance down
Posted September 5, 2007on:
So the latest finance firm to collapse was actually in good shape, until good old investor panic lead to a run on funds took it out. The eight company since May 2006, I bet you a lot of people feel scared now.
The main thing to remember is that this company was small, $19m owed to investors is peanuts compared to the size of the ‘finance firm’ market of $16b. This story would not have made news if it wasn’t for the 7 other companies had gone done in recent memory.
Here we have a game of complementary actions. If you believe that other investors are now going to dump the firm, the expected payoff from you dumping the firm rises. If you think other investors are more willing to loan to the firm, the expected payoff from staying with the firm rises. In this case we can have a co-ordination problem. The equilibrium where everyone stays with the firm would have been dominant in the case of LDC, but as peoples beliefs were affected by recent uncertainty, we ended up in a degenerate, sub-optimal equilibrium where LDC folded.
In cases like this, the government can find ways to steady the nerves of investors and prevent things like this from happening, for example by cutting the cash rate. However, as always with economics, there is a trade-off. If the monetary authority cut rates to save the good firms, they would create a moral hazard problem for the market in the future. Finance companies would believe that the government would bail them out, and so would be willing to take on more risk than is socially optimal.
As a result, the best government action would be to tell investors to relax, but do nothing substantial. A correction in the financial market will take out a few genuinely good finance companies. However, this is the price we must face for clearing out all the dead wood in the market, and ensuring that our financial sector functions more cleanly in the future.
Update: Another little finance firm has gone, this one is valued at $16m, Finance and Investments was its name. Its times like these we need someone to come onto TV and tell everyone to calm down, someone like Keynes. I miss Keynes. Note: This firm only went down as it was getting funding from LDC, as a result we can blame the damn run on funds for this as well. Damn you fund runners 😉