Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007

TLDR

The shadow banking system is a real banking system that can trigger a wholesale banking panic, a systemic event that renders the system insolvent when it cannot meet obligations. The study examines historical banking panics to understand the current crisis and inform regulatory reforms that could make the shadow banking system less vulnerable. The 2007 crisis was a banking panic in which financial firms ran on each other by not renewing repo agreements or raising haircuts, causing massive deleveraging and insolvency.

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 19th and early 20th 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 other 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.