Thursday, June 25, 2009

Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007

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.

Economists view the world as being the outcome of the “invisible hand,” that is, a world where private decisions are unknowingly guided by prices to allocate resources efficiently.1 The credit crisis raises the question of how it is that we could get slapped in the face by the invisible hand. What happened? Many private decisions were made, over a long time, which created the shadow banking system. That system was vulnerable to a banking panic. The U.S. had a banking panic starting in August 2007, one that continues today. But banking panics, you say, like the one in the movie “It’s a Wonderful Life,” don’t happen anymore.2 Indeed, until these recent events, most people did not think of banking panics as something to be concerned about. After all, the panics of the Great Depression are a dim memory. Since 1934 when deposit insurance was adopted, until the current panic – a span of almost 75 years – there had been no banking panics.

The period from 1934, when deposit insurance was enacted, until the current crisis is somewhat special in that there were no systemic banking crises in the U.S.3 It is the “Quiet Period” in U.S. banking. See the figure below.4 The figure shows the Great Depression very dramatically, but this event was very special, as discussed below. Looking at the figure, the Quiet Period in banking following the Great Depression is also clear. This Quiet Period led to the view that banking panics were a thing of the past.

The year 2008 does not show much because the figure is in terms of number of failures, not total assets of failed institutions; and it does not include failed investment banks or distressed mergers. The period of quiescence is related to what macroeconomists call “The Great Moderation,” a view associated with the observation that the volatility of aggregate economic activity has fallen dramatically in most of the industrialized world.5 One explanation for this is that there were no longer banking panics.6 From a longer historical perspective, however, banking panics are the norm in American history. And, obviously now the world is different; recent events are likely to lead to a revision of this view.

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