What You Will Learn in this Chapter

• 
  How depository banks and shadow banks differ
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  Why, despite their differences, both types of banks are subject to bank runs
• 
  What happens during financial panics and banking crises
• 
  Why the effects of panics and crises on the economy are so severe and long-lasting
• 
  How regulatory loopholes and the rise of shadow banking led to the financial crisis of 2008
• 
  How a new regulatory framework seeks to avoid another crisis

From Purveyor of Dry Goods to Destroyer of Worlds

The collapse of Lehman Brothers, the once-venerable investment bank, set off a chain of events that led to a worldwide financial panic.

Press Association via AP Images

IN 1844 HENRY LEHMAN, A GERMAN immigrant, opened a dry goods store in Montgomery, Alabama. Over time, Lehman and his brothers, who followed him to America, branched out into cotton trading, then into a variety of financial activities. By 1850, Lehman Brothers was established on Wall Street; by 2008, thanks to its skill at trading financial assets, Lehman Brothers was one of the nation’s top investment banks. Unlike commercial banks, investment banks trade in financial assets and don’t accept deposits from customers.

In September 2008, Lehman’s luck ran out. The firm had invested heavily in subprime mortgages—loans to home-buyers with too little income or too few assets to qualify for standard (also called “prime”) mortgages. In the summer and fall of 2008, as the U.S. housing market plunge intensified and investments related to subprime mortgages lost much of their value, Lehman was hit hard.

Lehman had been borrowing heavily in the short-term credit market—often using overnight loans that must be repaid the next business day—to finance its ongoing operations and trading. As rumors began to spread about how heavily Lehman was exposed to the tanking housing market, its sources of credit dried up. On September 15, 2008, the firm declared bankruptcy, the largest bankruptcy to date in the United States. What happened would shock the world.

When Lehman fell, it set off a chain of events that came close to taking down the entire world financial system. Because Lehman had hidden the severity of its vulnerability, its failure came as a nasty surprise. Through securitization (a concept we defined in Chapter 16) financial institutions throughout the world were exposed to real estate loans that were quickly deteriorating in value as default rates on those loans rose. Credit markets froze because those with funds to lend decided it was better to sit on the funds rather than lend them out and risk losing them to a borrower who might go under like Lehman had. Around the world, borrowers were hit by a global credit crunch: they either lost their access to credit or found themselves forced to pay drastically higher interest rates. Stocks plunged, and within weeks the Dow had fallen almost 3,000 points.

Nor were the consequences limited to financial markets. The U.S. economy was already in recession when Lehman fell, but the pace of the downturn accelerated drastically in the months that followed. By the time U.S. employment bottomed out in early 2010, more than 8 million jobs had been lost. Europe and Japan were also suffering their worst recessions since the 1930s, and world trade plunged even faster than it had in the first year of the Great Depression.

All of this came as a great shock because few people imagined that such events were possible in twenty-first-century America. Yet economists who knew their history quickly recognized what they were seeing: it was a modern version of a financial panic, a sudden and widespread disruption of financial markets. Financial panics were a regular feature of the U.S. financial system before World War II. The financial panic that hit the United States in 2008 shared many features with the Panic of 1907, whose devastation prompted the creation of the Federal Reserve system. Financial panics almost always include a banking crisis, in which a significant portion of the banking sector ceases to function.

On reflection, the panic following Lehman’s collapse was not unique, even in the modern world. The failure of Long-Term Capital Management in 1998 also precipitated a financial panic: global financial markets froze until the Federal Reserve rode to the rescue and coordinated a winding-down of the firm’s operations. Because the Federal Reserve resolved the LTCM crisis quickly, its fall didn’t result in a blow to the economy at large.

Financial panics and banking crises have happened fairly often, sometimes with disastrous effects on output and employment. Chile’s 1981 banking crisis was followed by a 19% decline in real GDP per capita and a slump that lasted through most of the following decade. Finland’s 1990 banking crisis was followed by a surge in the unemployment rate from 3.2% to 16.3%. Japan’s banking crisis of the early 1990s led to more than a decade of economic stagnation.

In this chapter, we’ll examine the causes and consequences of banking crises and financial panics, expanding on the discussion of this topic in Chapter 16. We’ll begin by examining what makes banking vulnerable to a crisis and how this can mutate into a full-blown financial panic. Then we’ll turn to the history of such crises and their aftermath, exploring why they are so destructive to the economy. Finally, we’ll look at how governments have tried to limit the risks of financial crises.