Banking Panics: Deja Vu All Over Again - Commentary by Gary Gorton

"Banking Panics: Déjà Vu All Over Again"
By Professor Gary Gorton
Published on the New York Times DealBook blog October 5, 2009 
Read the article in its original context on the New York Times website.

In the movie “It’s a Wonderful Life,” shown each year on television around Christmastime, there is a bank run on the Bedford Falls Savings and Loan. For most people, this is the only reference point for understanding a banking panic, unless you happen to have lived through the Great Depression and experienced firsthand the bank runs of the 1930s. Of course, it is good news that we did not have a generalized bank run between 1934, when deposit insurance was introduced, and 2007.

But now, having been through the Panic of 2007, it is clear that there is a lack of historical awareness and understanding of banking panics. And, what makes it worse is that the Panic of 2007 was not like the Bedford Falls Savings and Loan, where Bedford Falls’s citizens ran to their local bank to withdraw cash.

In August 2007, it was firms running on other firms, in a market that is not known, or seen, or understood by most people, including regulators, academics, journalists and politicians. Without seeing the panic directly, it has been difficult to make sense of the events. Effects were mistaken for causes. Many "explanations" have been proposed, and many evildoers have been nominated. But, the noise level, the hysteria, the witch hunts, the show trials and the finger-pointing are not productive in terms of financial reform. Real reform must be based on understanding what happened.

From the founding of America until 1934, banking panics were almost regularly occurring events, and exactly the same kind of finger-pointing and blame games happened over and over again, then as now.

The basic problem is straightforward. When you deposit $100 in a bank, the bank lends it out to someone who deposits the $100 in another bank until they need it. Then the second bank lends out the $100, and so on. The single $100 of currency ends up supporting a much larger amount of demand deposits (checking accounts). The demand deposits, created through this leverage, are counted as money, since you can spend demand deposits by writing checks. Since people can always go to their banks and demand currency back, banks are — by definition — dependent on short-term funding.
In the era before the Federal Deposit Insurance Corporation, people — upon realizing that a recession was looming — would quite rationally decide to withdraw currency from their bank, for fear that their bank might become insolvent in the recession and they would lose their savings. No one knew which banks were the weak ones, so rational depositors at all banks wanted to get their money back. Now, of course, the banks had lent the money out and they could not get the money back on demand. The bank loans were illiquid — that is, there was no place to sell these loans. So, the entire banking system was then insolvent, in the sense that it could not honor the (legal) demands of depositors for cash.

Society could have chosen to liquidate the banks, penalizing them for having created demand deposits (leverage) to use as money. This did not happen. And, indeed it took about 100 years until society decided that it was best to put people in a position where they did not have to worry about their checking accounts; deposit insurance was enacted.

In the last 30 years or so, as the global economy has expanded, another banking system, which works almost the same way, has developed. This is a banking system that also creates money, demand deposits of a sort, for corporations and institutional investors. A large pension fund seeking a place to save cash for a short time, earn interest and be assured that the cash is safe, cannot deposit in a regulated bank because the amount guaranteed by government deposit insurance is limited. Instead that firm will deposit the cash with a financial firm for a short time (typically overnight), earn interest and receive a kind of guarantee by accepting a bond as collateral for their deposit (usually a AAA-rated bond). This market is the sale and repurchase (“repo”) market.

The Federal Reserve used to count repo, rightly, as money (in a monetary aggregate called M3) and so some limited information about this market was collected. But the Fed’s calculation of M3 was discontinued in mid-2006, as the repo market was in fact growing to enormous size. So, there is no data on the overall size of the repo market, but a reasonable guess is that it is at least as large as the regulated bank sector, $10 trillion.

In a repo market transaction, the AAA bond which is used as collateral is a kind of currency, and the repo is the counterpart to the demand deposit. It’s different from the usual demand deposit. When the institutional investor deposits cash and receives the bond as collateral, that bond can be "spent" in that it can be used as collateral in another unrelated transaction. And, then that third party can use the bond again somewhere else.

But, you say, should we allow that? The same thing happens with demand deposits. We can always have 100 percent reserve banking: make the bank keep the $100, in the above example, and not lend it out. But, then we don’t have loans (which have always been the assets of banks); clearly that would be a problem.

A problem with the new banking system is that it depends on AAA collateral to guarantee the safety of the deposits. But, there are many demands for such collateral. Foreign governments and investors have significant demands for United States Treasury bonds, and these are also needed to collateralize derivatives positions. Further, they are needed to use as collateral for clearing and settlement of financial transactions. There are few AAA corporate bonds. The demand for collateral has been largely met by securitization, a 30-year-old innovation that allows for efficient financing of loans. Repo is to a significant degree based on securitized bonds as collateral, a combination called "securitized banking."

The shortage of collateral for repo, derivatives and clearing-settlement is reminiscent of the shortages of money in early America, which is what led to demand deposit banking.

Securitized banking is like the pre-F.D.I.C. banking system. If the depositors become concerned that their deposits are not safe, they can withdraw from the bank by not renewing their repo. Why would depositors become concerned? After all, they have the collateral, and if the bank fails they are allowed to sell the collateral and keep the money. But, if there is a concern that many collateral holders will be selling at the same time, it may be best not to engage in repo. You can see how the panic could happen.

Subprime bonds are not significant enough in quantity to cause a systemic crisis. But if depositors are not sure where that risk is and which banks are vulnerable, and if they are concerned about being able to sell collateral, they might withdraw. Unlike in "It’s a Wonderful Life," firms are now running on firms.

From the banks’ point of view, repo is financing, so if depositors withdraw, then the banks are in the same position as banks in the 19th century. There is no place to sell enough assets to meet depositor demands, and the securitized banking system is insolvent (as the accountants dutifully record).

Policy makers need to recognize that the securitized banking system is important for economic growth. It needs to be protected and its vulnerabilities need to be addressed. That sounds a lot like advice given in the aftermath of the Panic of 1837.

Gary Gorton is the Frederick Frank Class of 1954 professor of management and finance at the Yale School of Management.