Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007
Yale and NBER
Prepared for the Federal Reserve Bank of Atlanta
2009 Financial Markets Conference: Financial
Innovation and Crisis, May 11-13, 2009
This version: May 9, 2009
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.
banking panic is a systemic event because the banking
cannot honor its obligations and is
. Unlike the historical banking panics of the 19
and early 20
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 o
ther financial firms
by not renewing sale and repurchase agreements (repo) or increasing the repo
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.
+ This paper draws on a number of current research projects with several coauthors. I acknowledge their
influences on my thinking and thank them: Tri Vi Dang, Bengt Holmström, and Andrew Metrick.
particular, I thank Bengt Holmström for reminding me of the relevance of my own work with George
Pennacchi when he discussed Gorton (2008). For help with data I thank Craig Furfine, Richard Grossman
and various participants in the capital markets.
Thanks to James Aitken, David Andolfatto, Charles
Calomiris, Tri Vi Dang, Richard Grossman, Ping He, Ananth Krishnamurthy, Maury Obstfeld, Maureen
Hara, Ashraft Rizvi, Rich Rosen, Gabe Rosenberg, Amit Seru, and Manmohan Singh for comments.