“Yale and NBER / Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”

Abstract: The “shadow banking system,” at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms “running” on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin (“haircut”), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic.

Comment: What the global banking system, primarily that of the developed world, faced starting in the summer of 2007 was a 21^st century bank run. Over the past thirty years the development of the “shadow” banking system allowed for more liquidity of previously less than liquid loans. This rise in liquidity of various assets and liabilities coupled with the ascendency of derivatives and growth in short term financing via repurchase agreements or repos all contributed to the eventual “run” on financial institutions when the repo market lenders began demanding more collateral against their borrowed funds.