Fed Chairman Cites Research by Profs. Gorton and Metrick in Speech on Financial Crisis

In remarks on the financial crisis delivered at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke drew on research by Gary B. Gorton, Frederick Frank Class of 1954 Professor of Management and Finance, and Andrew Metrick, Theodore Nierenberg Professor of Corporate Governance and Professor of Finance, and Faculty Director of the Millstein Center for Corporate Governance and Performance.

In his speech, "Reflections on a Year of Crisis," Bernanke discussed the events of the financial crisis during the past year and the policy responses that helped to avert a collapse of the global financial system. He told the annual gathering of central bankers and economists that the crisis can be interpreted, in part, as a "classic panic" with runs on short-term funding suppliers to financial institutions rather than depositor runs on traditional retail banks. Bernanke referenced two papers — "Reputation Formation in Early Bank Note Markets," by Gorton and "Securitized Banking and the Run on Repo" by Gorton and Metrick — in his explanation of one panic scenario that arose among lenders in the short-term sale and repurchase agreement, or "repo," market.

In "Securitized Banking and the Run on Repo," Gorton and Metrick argue that the current crisis is a system-wide bank run that they describe as "a run on repo." They provide an analysis of how the first run on the repo market that took place in August 2007 caused the problems in the subprime mortgage market to spread into a systemic event. They write, "The location and size of subprime risks held by counterparties in the repo market were not known and led to fear that liquidity would dry up for collateral, in particular non-subprime related collateral. Uncertainty led to increases in the repo haircuts [the amount of collateral required for a given repo transaction], which is tantamount to massive withdrawals from the banking system." Bernanke drew an analogy between the increased haircuts that repo lenders required during the crisis and the discounting of U.S. bank notes that occurred during the American Free Banking Era, which Gorton describes in "Reputation Formation in Early Bank Note Markets" (Journal of Political Economy, 1996). 

Bernanke previously recommended Gorton’s paper "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007," about the shadow banking system and its vulnerability to a panic, in a Washington Post interview.