Gary Gorton’s new paper

by on May 18, 2009 at 7:39 am in Economics | Permalink

Find it here, with this 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.

Addendum: Arnold Kling summarizes some of the recommendations:

1. Senior tranches of securitizations of approved asset classes should be insured by the government.
2. The government must supervise and examine "banks," i.e.,
securitizations, rather than rely on ratings agencies. That is, the
choices of asset class, portfolio, and tranching must be overseen be
examiners.
3. Entry into securitization should be limited, and any firm that enters is deemed a "bank" and subject to supervision.

Bob Murphy May 18, 2009 at 9:05 am

[D]epositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent.

Opponents of fractional reserve banking would say the banking system always was (and continues to be) insolvent. It didn’t suddenly become insolvent in 1907.

Mattyoung May 18, 2009 at 9:34 am

When some large constraint in the economy suddenly appears, the financial system reacts the most rapidly. Changing financial regulation is part of the resulting structural change in financial services, but we should remember that it is not the financial system that caused the original shock.

Diversity May 18, 2009 at 1:32 pm

Great paper on part of US financial history. Lots of good description of the development of the current mess. But the recommendations look unexpectedly amateur.

Mattyoung

Shocks occur. A financial system without adequate dampers and shock absorbers is not fit for purpose.

will mcbride May 18, 2009 at 8:57 pm

I don’t understand how Gorton can honestly review the history of pre-Fed banking in the US and conclude that the frequent panics were all market failures and that federal deposit insurance finally saved the day in 1934. Does he know anything about the experience of free banking in Scotland or Canada or Australia? Panics occurred in the pre-Fed US precisely because of severe regulatory restrictions on branch and interstate banking and the bond-deposit requirement for bank note issuance. These regs didn’t exist in Scotland, Canada, or Australia in the 19th century and things worked out great. Gorton’s whole analysis stems from this assumption, so naturally he thinks federal deposit insurance should be extended to the shadow banking system. Instead, I think it’s more likely that the shadow banking system, as the name implies, has evolved to avoid the regulations and the regulators and will continue to do so with each new regulation.

pool cues November 10, 2009 at 11:21 am

Thanks for sharing the post. I’ve learned a lot of financial history in the US.

whole house water filtration system March 11, 2010 at 2:07 pm

yes, shocks occur. the current system was a little too good in absorbing shocks. it would have been much better if we had had large-scale failure earlier.

what we need is some kind of trigger like (real rate of return is negative => failure). if it looks like they are paying you to borrow money, it’s too good to be true.

Jeremy
whole house water filtration system

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