Professor Gary Gorton Testifies on Causes of the Financial Crisis

Posted on: February 26, 2010
Reposted: March 1, 2010

Gary Gorton, the Frederick Frank Class of 1954 Professor of Management and Finance, was among the experts convened by the Financial Crisis Inquiry Commission (FCIC) to explore the causes of the financial crisis. The invited participants presented working papers on the key issues and events leading up to the crisis and its underlying causes at a forum on February 26 and 27 in Washington, DC. The forum was part of the FCIC’s ongoing hearings to inform its formal report on the crisis to be presented to Congress and the President by the end of the year.
 
In his testimony, Gorton presented his paper "Questions and Answers about the Financial Crisis" which focuses on the securitized or "shadow" banking system’s role in the financial crisis. Gorton explained that the shadow banking system, which allows institutional investors and firms to make short-term deposits, is a genuine banking system that is as large as the traditional, regulated banking system, and it experienced a system-wide panic. Unlike earlier bank panics in history where depositors ran to their banks to withdraw money from their accounts, the shadow banking system experienced a run in the short-term sale and repurchase ("repo") market. Financial firms ran on other financial firms.

Gorton writes, "The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability."

Gorton’s research on the shadow banking system has been recommended by Federal Reserve Chairman Ben Bernanke and is the subject of Gorton’s new book Slapped by the Invisible Hand: The Panic of 2007 (Oxford University Press).