This report by Gary Gorton from Yale, and the National Bureau of Economic Research, was presented to the US Financial Crisis Inquiry Commission. The report describes the changes that had taken place in the banking system prior to the crisis which were not well understood by academics and by many government regulators. A shadow or parallel banking system had developed which was equal in size to the traditional banking system. The financial crisis was caused by a bank run on the shadow banking system. The shadow banking system functions as an intermediator between investors and the traditional banking system. It became a major source of funds for the traditional banking system. This report describes the structure of the banking system and explains how the run on the shadow banking system led to the global financial crisis.
Traditional banks borrow money from depositors and pay a low interest rate for the deposits because they can be withdrawn on demand by the depositor by the simple act of writing a check. They make money by investing in longer term assets such as Treasuries or loans which pay a higher rate of interest. Traditional banking became less profitable, starting in the 1980's. As a result the banks began to originate loans and sell them to investment banks. Thus the investment banks became a source of funding to the traditional banks, and they were able to use the loans that they purchased as collateral for deposits that they received from a different group of depositors. For example, Fidelity may have $500 million in cash, on which it would like to earn interest until it might be needed. Fidelity would deposit the $500 million in the investment bank but it does not want to take a risk on the deposit. The investment bank would "sell" a $500 million security to Fidelity which it agrees to repurchase at face value. Therefore, Fidelity is protected from risk as long as the $500 million security retains its value. The investment bank is also protected as long as the asset retains its value. It is at risk if the asset loses value because it has agreed to repurchase the asset at face value. These agreements were typically short term. Fidelity might earn 3% on its deposit, and the investment bank might earn 6% on the assets that it held. In other words, the investment bank was operating as a depository bank by borrowing short term, and by investing long term at higher interest rates.
This market became known as the "repo" market and it grew to become a bit larger than the traditional depository banking system. There is a key difference, however, between the two systems. The depository banking system is protected from mass withdrawals by depositors because their deposits are insured by government (FDIC). The shadow banking system is not insured by government. It is at risk if depositors, like Fidelity, become concerned about the value of the securities that it holds as collateral. In fact that is what happened. For example, suppose that Fidelity decided that the $500 million security that was offered as collateral for its $500 million deposit might be worth only $400 million. The investment bank would be forced to provide $100 million of additional security. In essence that would be like a withdrawal of $100 million from the investment bank. It would be forced to sell off other assets to meet Fidelity's demand. If other customers made the same demands, the investment bank would be forced to sell even more assets and the market value of these assets would decline if the "fire sale" proceeded. That is what happened. Investment banks, like Lehman and Bear Stearns were unable to meet their needs for capital on the "repo" market, and the forced sale of assets at lower prices made them insolvent. The government stepped into this market and rescued Bear Stearns by a forced sale to JP Morgan but it let Lehman enter into bankruptcy. The government also was forced to provide liquidity to the remaining investment banks in order to prevent a wholesale sale of assets at fire sale prices which would make them insolvent as well.
The US Fed was criticized for making a claim that the sub-prime market was not large enough to present a risk to the entire banking system but it did not realize how it would affect the repo market on which the investment banks depended for capital. An analogy was used by Gorton to describe what happened. Suppose that e-coli was suspected in the beef market but nobody knew the source the of e-coli. Everyone would stop purchasing beef until the source was found. Something like that happened in the repo market. Investors knew that some securities were infected with sub-prime but they did not know which one's were infected. The securitization market and the repo market which depended upon it collapsed. This market has not fully recovered and governments have not taken actions to prevent further deterioration of this market that might result from other derivatives like the sub-prime infected securities.
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