Gary Gorton has written an excellent book, making the point that the crisis of 2007 was in fact an old-school bank run in the shadow banking system. His main support is figure 2.6 on page 26 in conjunction with figure 2.12 on page 48. The former shows average daily overdrafts, which shrunk from $70 billion to below $10 billion, and average repo haircut on structured debt, which went from 0% to 45% from late 2007 to late 2008.
Gorton’s point is that banking is nowadays done in the shadow banking system via repo. Firms lend out cash/deposits for a certain amount of time against collateral. Part of this collateral was mortgage-backed assets. When these turned bad, nobody knew where these were. Therefore, a haircut on structured debt accepted as collateral in repo was demanded. Since nobody knew where the “toxic debt” was, firms did not trust the players in the shadow banking system anymore – liquidity dried up, causing the financial crash.
On p. 51, Gorton notes that banking relies on information-insensitive debt. In the banking sector, these are insured deposits. In the shadow banking sector, these are almost-safe assets with AAA, like government bonds and other very safe assets. However, some of these very safe assets turned out to be “bad apples”, since they contained mortgage-backed assets. However, it was impossible to find out which of the structured debt (CDOs, CDOs squared, SIV, …) contained them, leading to a lemons market.
Gorton’s solution then is government insurance for the assets used in shadow banking (p. 56): “That is the modern equivalent of saying that consumers need insurance for their demand deposits. … The government would have borne the losses … and a systemic event would have been avoided”. It is here where I disagree with Gorton. While his exhibition of the shadow banking system’s bank run is well-informed and persuading, his solution is not. Gorton would have needed to step one step back from the system he is looking at: is the financial system we have producing real wealth? Personally, I do not think so.
Capital has been flowing from a developing country (China) to the US, which is hard to justify with economic logic. As a result of this flow, money was misallocated by the financial system. The real estate bubble is the product of this misallocation. While this was happening, those in the financial sector earned billions in bonuses on top of very high wages. Before you can tell me how to save the shadow banks, I need to see empirical data to confirm that this system works for the benefits of those concerned (savers and investors), and not only to the benefit of those making the deals working for the shadow banks.
A financial system should provide high returns to savers and low interest rates to investors. Naturally, this is a trade-off. As it stands, however, it seems that we have low returns to savers combined with high interest rates (and credit rationing) for investors. That is the worst combination possible, and it has been brought about by the same unregulated shadow banking system that Gary Gorton has exposed so well in his book. Therefore, I praise the book. I recommend to everybody who wants to understand how “banking” nowadays works – and fails. Whether this system should be given a chance to evolve further is an issue that should be discussed.
econoblog101 
[…] noteworthy because he seems to finally have understood what happened (see Gorton’s book which I reviewed in July). For the first time since the crisis broke out I believe that the Fed has regained some […]
By: Gary Gorton replaces Gordon Gekko at the Fed | on September 24, 2010
at 7:58 pm
[…] Let me point out that Gary Gorton said the same thing before. I reviewed his book in July 2010. Here is an excerpt: On p. 51, Gorton notes that banking relies on […]
By: The ECB finally gets it – or doesn’t it? « econoblog101 on February 10, 2012
at 11:18 am