Wednesday, November 21, 2012

We Need To Do A Lot More To Prevent Future Runs On The Shadow Banking System

Gary Gorton was a consultant at AIG in London when it was crushed by a run on the shadow banking system.  Investment banks had securitized mortgages and they were selling them to investors.  They were also using the securities as collateral for short term loans from money market funds.  That was the essence of the shadow banking system which reached $62 trillion by 2007.  The investment banks depended upon turning over short term debt to maintain liquidity.  When the securities that they used for collateral lost their AAA rating, they were unable to roll over their short term loans from money market funds.  That was just like what happens in a run on the depository banking system when depositors withdraw their funds.  The investment banks were unable to borrow money using mortgage securities as collateral and hedge funds withdrew their funds as well.  The financial crisis was really precipitated by a run on the shadow banking system.

The securitization system that provided $62 trillion in 2007 is moribund today.  The question is how we restore that system and make it less susceptible to bank runs.  One of the problems is that our measurement systems, which were based upon outmoded models of banking and money, did not even detect the $62 trillion giant that had been created.  This raises questions about our measurements systems and our ability to prevent future runs on the shadow banking system.

No comments:

Post a Comment