SSRN-id1401882

SSRN-id1401882 - Slapped in the Face by the Invisible Hand:...

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Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007 + Gary Gorton Yale and NBER Prepared for the Federal Reserve Bank of Atlanta ’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13, 2009 This version: May 9, 2009 Abstract 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 19 th and early 20 th 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 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. + 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. In 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 O’ Hara, Ashraft Rizvi, Rich Rosen, Gabe Rosenberg, Amit Seru, and Manmohan Singh for comments.
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1 The Panic - Scenes in Wall St reet Wednesday Morning,” May 14, 1884, Harper’s Weekly , vol. 28, no. 1431, p. 333; drawn by Schell and Hogan.
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2 “The American panic of 1907 … gave the lie directly to those who in recent years have contended that we should never again witness experiences like those of the memorable years 1837, 1857, 1873, and 1893.” Andrew (1908 a, p. 290). 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
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This note was uploaded on 12/26/2011 for the course ECON 208 taught by Professor Staff during the Fall '08 term at UCSB.

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SSRN-id1401882 - Slapped in the Face by the Invisible Hand:...

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