This article reviews a book by Yale professor Gary Gorton who observed the run on the shadow banking system from AIG's London office. Gorton argues that we have always had greed in the banking system. Therefore, the financial crisis cannot be explained by greed. It may have been a contributing factor, but all banking crises are caused by runs on the bank. That happened in the Great Depression, and we created the FDIC which insured bank deposits. That has prevented runs on depository banks. The shadow banking system is about as large as the depository banking system, and there is nothing to prevent a run on the shadow banking system. We observe the failure of banks like Lehman Brothers, but most have not understood the cause.
The shadow banking system is based upon a system in which investment banks use securities as collateral for short term loans. In turn, they use these funds to invest in longer term assets that provide a return greater than the interest rate which they pay to borrow on the short term market. Banks cannot create riskless assets. Therefore, when the assets of investment banks were perceived as risky, $1.2 trillion was withdrawn from dealer banks. This forced the sale of assets causing the prices of those assets to plummet in value. The government was forced to take actions to deal with the bank run but it was not entirely successful. Therefore, government got blamed for the problems in the shadow banking system. The real problem is that government had taken no actions to prevent a run on the shadow banking system.
Gorton argues that the system of securitizing bank assets is an essential part of the financial system. It had been working well prior to the financial crisis. We should be taking actions that will prevent future runs on the shadow banking system instead of doing many of the things that are included in Dodd Frank.