Friday, March 26, 2010

"Deposit Insurance" for the Shadow Banking System

Here are some more thoughts inspired by Gary Gorton's work and discussions at the Economics Blogger Forum. During the Great Depression of the 1930s there were runs on the banking system. These panics were based on depositors rushing to get their money back from the banks. The federal government response was to create deposit insurance. This response worked but it also created moral hazard problems that, in turn, required more government regulation.

During the Great Recession of the late 2000s something similar happened. There was a run on the shadow banking system in the repurchase agreement (repo) market by institutional investors and nonfinancial firms. Repos represent a liability for the shadow banking system just as deposits do for the traditional banking system. According to Gorton, the repo market is around $12 trillion in size (compared to about $10 trillion in assets for the traditional U.S. banking system) so this was a major bank run. Like deposit holders during the Great Depression, repo holders in this crisis wanted their money back and could get it by (1) forcing the shadow banks to take a haircut on the collateral used in repos or (2) not renewing the repos . As a result, repo markets began freezing up and threatened the shadow banking system. Since the shadow banking system is a conduit for funding the traditional banking system, financial intermediation in general became threatened (See Gorton for more details). The official response to this banking panic was for the Federal Reserve to create liquidity programs to effectively unthaw the repo market. Like deposit insurance in the 1930s, this government intervention stopped the run on the shadow banking system. Now that these liquidity facilities have been tested and shown to work, there is an expectation they will be used again if needed. And like the deposit insurance for the traditional banking system, this modern form of "deposit insurance" for the shadow banking system is bound to create moral hazard problems that will ultimately lead to more government regulation. These are interesting parallels.

The emergence of the shadow banking system, therefore, not only has implications for the correct measure of the money supply, but also for what will be the new moral hazard and government regulation of the financial system.

4 comments:

  1. "The emergence of the shadow banking system, therefore, not only has implications for the correct measure of the money supply, but also for what will be the new moral hazard and government regulation of the financial system."

    That right. But it's not an implication. Politically, the Shadow Banking System will be guaranteed, even if we call it "implicitly", and investors will behave based upon that knowledge.

    We're left trying to decide how to minimize the taxpayer's risk. I'm for Narrow/Limited/Utility Banking, precisely because we need some kind of buffer from this implicit guarantee. I think it also makes Monetary Policy easier as well.

    Don the libertarian Democrat

    ReplyDelete
  2. Don, what is narrow/limited/utility banking?

    ReplyDelete
  3. David,

    Here's an approach I like:

    http://www.amazon.com/Jimmy-Stewart-Dead-Financial-Strikes/dp/0470581557/ref=sr_1_9?ie=UTF8&s=books&qid=1259679868&sr=8-9

    Take care,

    Don

    ReplyDelete
  4. Some reviews:

    "Jimmy Stewart Is Dead is a page-turner, as fast-paced as The Simpsons, with new insights on every page. As fun as it is, Jimmy Stewart is also deadly serious. It describes our deep financial problems and offers an amazingly simple financial fix to prevent an even worse crash. Everyone should read this book."
    —GEORGE AKERLOF, Koshland Professor of Economics, University of California at Berkeley, Nobel laureate in Economics

    "Kotlikoff's book makes an impassioned, coherent, and convincing case for Limited Purpose Banking."
    —ROBERT E. LUCAS, Jr., John Dewey Distinguished Professor of Economics, University of Chicago, Nobel laureate in Economics

    "This book is 'must' reading for everyone who cares about the future of the American economy."?
    —ROBERT W. FOGEL, Walgreen Distinguished Service Professor, University of Chicago, Nobel laureate in Economics

    "Kotlikoff is right. Unless we institute fundamental reforms, there will be an even greater crisis. This well-written book is a must-read for those concerned with reforming the financial system."
    —EDWARD C. PRESCOTT, W. P. Carey Chair in Economics, Arizona State University, Nobel laureate in Economics

    "Certainly we need to abandon today's hazardous financial system. Kotlikoff's Limited Purpose Banking plan is one of the best visions to surface so far."
    —EDMUND PHELPS, McVickar Professor of Political Economy, Columbia University, Nobel laureate in Economics

    ReplyDelete