By Roberta Kwok
The financial meltdown of 2007-08 took economists by surprise. Before that, the United States hadn’t suffered from a major crisis since the Great Depression. “There was this unthought assumption that we wouldn’t have one,” says Gary Gorton, the Frederick Frank Class of 1954 Professor of Finance at Yale SOM. “They said, don’t worry about it.”
So why did the banking system break down? Contrary to the popular narrative, the reason was not simply greed, Gorton argues. “There’s an inherent problem with banking,” he says. “And the inherent problem has to do with the nature of their debt.”
One of the functions of banks is to issue short-term debt—which means the lender can get their money back typically in a week or less. For example, when a customer deposits funds in a checking account, she is lending money to her bank. She can get that money back whenever she wants by withdrawing cash or writing a check. As Gorton explains in a new paper, the price of short-term debt is fixed. If a customer writes a check for $100, the recipient accepts that the check is worth $100 and doesn’t argue about its value.
Leading up to the 2007-08 crisis, a kind of short-term debt called the sale and repurchase agreements (repo) market became popular. The process worked like this: A large lender, such as Fidelity, wanted to store money overnight and earn interest. So Fidelity lent, say, $500 million to an investment bank such as Goldman Sachs. To assure Fidelity that its money was safe, Goldman Sachs provided collateral.
With short-term debt, Gorton says, “no one is going to produce information about what’s backing this debt.” The lender doesn’t have time to analyze the collateral in detail. “That collateral has got to be something that Fidelity just takes, no questions asked,” he says. In the repo market, the debt was often backed by securitized bonds, created by pooling together income-creating assets like mortgages.
The problem arises when lenders start questioning the value of the collateral, as they did in 2008. “Everybody thinks, oh wait a minute, this collateral isn’t any good,” Gorton says. Since the price is fixed, the only factor that can change is the amount being lent. In other words, lenders stop lending money to the banks, cutting off their supply of cash—essentially, a bank run. “If you’re Goldman Sachs, and you’re 50% funded in the repo market, and the day comes when the lenders decide they don’t want to lend to you anymore, then you have a really big problem,” Gorton says. Banks were forced to sell assets, and prices plunged.
Regulators have tried to prevent such crises in two ways. One is requiring that short-term debt be backed by high-quality collateral. However, “that’s a system that has never really worked successfully,” Gorton says.
For instance, the U.S. National Banking Acts in the 1860s required national banks to back their money with U.S. Treasury bonds. But Treasuries were in short supply because other companies wanted them too. So a shadow banking system developed, under which checking accounts were backed by loan portfolios. Whenever customers got nervous about their banks’ stability, they lined up to get their money back, spurring frequent crises over the next half-century.
In 1933, the U.S. instituted deposit insurance nationwide, meaning that the government would back up the banks. That worked from 1934 to 2007, “which kind of lulled people into this false sense of security,” Gorton says.
So what happened in 2007? Although the repo market was a form of short-term debt, it wasn’t insured. “No one considered it part of banking,” he says.
Regulators need to find all types of short-term debt, measure it, and impose safeguards, Gorton says. Some short-term debt may be issued by companies that aren’t considered banks. “But if some firm is issuing it, in fact it is a bank,” he says. “And it’s vulnerable to runs because, by design, the price is fixed.”
But regulation of short-term debt is not the only answer. If a bank—that is, an organization that issues this type of debt—doesn’t like the rules, it can simply migrate into an unregulated shadow banking system.
So how can banks be kept in the regulated system? The answer lies with their charter value, Gorton says. Setting up a bank requires a license, and the license allows the company to get insurance on deposits. Licensed banks have local monopolies and thus reap extra profits, he says. Charter value is the value of those monopoly profits.
“The way you keep banks in the banking system is you allow them to have charter value,” he says. “Then they want to be a bank, and they don’t want to risk losing their valuable monopoly license.”
Paying attention to these issues is key to preventing more financial crises, Gorton says. To avoid a repeat of 2007-08, “you need to know what exactly causes the crisis,” he says. “And that means understanding what exactly a bank is.”