Floyd Norris of the New York Times, in a column widely blogged about, calls last week’s financial market events “the 21st-century equivalent of a run on a bank.” But the comparison doesn’t hold water. Securities markets and hedge funds are not structured like banks, and investor liquidations of positions are not like checking-deposit withdrawals.

Norris writes:

A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough. For a long time, that all seemed to be safely relegated to the past. But now the runs are back — and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.

… a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.

There is a very basic flaw in Norris’s comparison. A bank depositor has a claim against the bank for redemption on demand into a fixed number of dollars. He runs on the bank out of fear that the last in line to demand redemption will get less than par value. A security holder has no such claim to redemption on demand. If he wants immediate cash, he can sell his security in the market at the currently prevailing price. Security prices are marked to market every day, so the seller has no incentive to run. There is no expected gain from being first rather than last in line to sell. There is no equivalent of a run.

Mark Thoma endorses and expands the comparison, applying it to hedge funds rather than securities. Better, but it still doesn’t fit. Writes Thoma:

Floyd Norris makes a good point about modern bank runs, or something just like them. The problem is that entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs. Here's how it works.

Hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market.

But like a bank who lends out most of the deposit it receives, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio. Thus, unless it has substantial cash reserves on-hand (part of the scramble now is to build cash reserves), when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

… And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems get worse as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

Thoma neglects three basic institutional facts about hedge funds. First, their shares are sold only to high-net-worth investors, so we need shed no tears about hedge fund collapses impoverishing anyone.

Second, hedge fund shares are not checking accounts, so hedge fund losses do not threaten the payment system.

Third and most importantly, hedge fund share liquidations are usually subject to an advance-notice clause or “lock-up period” of one to two years. For this reason they cannot be run upon: investors simply do not have the option of demanding immediate liquidation. Hence there can be no problem of fire-sale losses from the fund being forced into hasty liquidation, what standard theory identifies as the inefficient result of a bank run.

There does exist, however, a secondary market for hedge fund shareholders who want to get out, namely Hedgebay. There shares can be sold to other investors who are willing to get in, at whatever discount or premium is necessary to clear the market.

The current problem at hedge funds is not self-feeding runs, but bad investments. Leveraged hedge funds have collapsed because of losses on bad assets, not because of withdrawals and fire-sale losses.

There is no good rationale for a “standing lending facility,” such as suggested by Thoma, to provide subsidized liquidity to hedge funds. Much less is there any rationale for “hedge fund insurance” to investors.