Shadow Banks and the Re-emergence of Bank Runs

Because a depository bank keeps on hand just a small fraction of its depositors’ funds, a bank run typically results in a bank failure: the bank is unable to meet depositors’ demands for their money and closes its doors. Ominously, bank runs can be self-fulfilling prophecies: although a bank may be in fine financial shape, if enough depositors believe it is in trouble and try to withdraw their money, their beliefs end up dooming the bank.

To prevent such occurrences, after the 1930s the United States (and most other countries) adopted wide-ranging banking regulation in the form of regular audits by the Federal Reserve, deposit insurance, capital requirements and reserve requirements, and provisions allowing troubled banks to borrow from the Fed’s discount window.

Shadow banks, though, don’t take deposits. So how can they be vulnerable to a bank run? The reason is that a shadow bank, like a depository bank, engages in maturity transformation: it borrows short term and lends or invests longer term. If a shadow bank’s lenders suddenly decide one day that it’s no longer safe to lend it money, the shadow bank can no longer fund its operations. Unless it can sell its assets immediately to raise cash, it will quickly fail. This is exactly what happened to Lehman.

Lehman borrowed funds in the overnight credit market (also known as the repo market), funds that it was required to repay the next business day, in order to fund its trading operations. So Lehman was on a very short leash: every day it had to be able to convince its creditors that it was a safe place to park their funds. And one day, that ability was no longer there. The same phenomenon happened at LTCM: the hedge fund was enormously leveraged (that is, it had borrowed huge amounts of money)—also, like Lehman, to fund its trading operations. One day its credit simply dried up, in its case because creditors perceived that it had lost huge amounts of money during the Asian and Russian financial crises of 1997–1998.

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Bank runs are destructive to everyone associated with a bank: its shareholders, its creditors, its depositors and loan customers, and its employees. But a bank run that spreads like a contagion is extraordinarily destructive, causing depositors at other banks to also lose faith, leading to a cascading sequence of bank failures and a banking crisis. This is what happened in the United States during the early 1930s as Americans in general rushed out of bank deposits—the total value of bank deposits fell by 35%—and started holding currency instead. Until 2008, it had never happened again in the United States. Our next topic is to explore how and why bank runs reappeared.

The Day The Lights Went Out at Lehman

On Friday night, September 12, 2008, an urgent meeting was held in the New York Federal Reserve Bank’s headquarters on Wall Street. Attending was the outgoing Bush Administration’s Treasury Secretary, Hank Paulson, and then head of the New York Fed, Tim Geithner (later the Treasury Secretary in the Obama Administration), along with the heads of the country’s largest investment banks. Lehman Brothers was rapidly imploding and Paulson called the meeting in the hope of pressing the investment bankers into a deal that would, like the LTCM bailout described in Chapter 16, avert a messy bankruptcy.

Since the forced sale of the nearly bankrupt investment bank Bear Stearns six months earlier to a healthier bank, Lehman had been under increasing pressure. Like Bear Stearns, Lehman had invested heavily in subprime mortgages and other assets tied to real estate. And when Bear Stearns fell as its creditors began calling in its loans and other banks refused to lend to it, many wondered if Lehman would fall next.

Richard Fuld, the head of Lehman, testified before a congressional panel on how the collapse of Lehman precipitated a financial panic.
Alex Wong/Getty Images

In July 2008, Lehman reported a $2.8 billion loss for the second quarter of 2008 (the months April–June), precipitating a 54% fall in its stock price. As its share price fell, Lehman’s sources of credit began to dry up and its trading operations withered. CEO of Lehman, Richard Fuld, began a desperate search for a healthier bank to buy shares of Lehman and provide desperately needed funding. By early September 2008, Lehman’s loss for the third quarter had risen to $3.9 billion. On September 9, J.P. Morgan Chase, a far healthier investment bank that had been Lehman’s major source of financing for its trades, demanded $5 billion in cash as extra collateral or it would freeze Lehman’s accounts and cut off its credit. Unable to come up with the cash, Lehman teetered on the edge of bankruptcy.

In the September 12 meeting, Treasury Secretary Paulson urged the investment bankers to put together a package to purchase Lehman’s bad assets. But, fearing for their own survival in an extremely turbulent market, they refused unless Paulson would give them a government guarantee on the value of Lehman’s assets. The Treasury had made the Bear Stearns sale possible by arranging a huge loan from the New York Fed to its purchaser. This time, facing a backlash from Congress over “bailing out profligate bankers,” Paulson refused to provide government help. And in the wee hours of Monday morning, September 15, 2008, Lehman went down, declaring the most expensive bankruptcy in history.

Yet, as Fuld had earlier warned Paulson, the failure of Lehman unleashed the furies. That same day the U.S. stock market fell 504 points, triggering an increase in bank borrowing costs and a run on money-market funds and financial institutions around the world. By Tuesday, Paulson agreed to an $85 billion bailout of another major corporation, the foundering American International Group (AIG), at the time the world’s largest insurer. Before the markets stabilized months later, the U.S. government made $250 billion of capital infusions to bolster major U.S. banks. Whether or not Paulson made a catastrophic mistake by not acting to save Lehman is a matter likely to be debated for years to come.

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Quick Review

  • There is a trade-off between liquidity and yield. Without banks, people would make this trade-off by holding a large fraction of their wealth in idle cash.
  • Banks allow savers to make a superior choice in their liquidity–yield trade-off because they engage in maturity transformation. Savers can have immediate access to their funds as well as earn interest on those funds.
  • Since 1980 there has been a steady rise in shadow banking because shadow banks—nondepository financial institutions that engage in maturity transformation—have largely been unregulated, allowing them to pay a higher rate of return to savers. At the time of the Lehman failure, shadow banking was about 1.5 times larger than the depository banking sector.
  • Because shadow banks, like depository banks, engage in maturity transformation, they can also be hit by bank runs. Shadow banks depend on short-term borrowing to operate; when short-term lenders won’t lend to a shadow bank, their refusal causes the bank to fail.

Check Your Understanding 18-1

    • Question

      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
      This is not an example of maturity transformation because no shortterm liabilities are being turned into long-term assets. So it is not subject to a bank run.

    • Question

      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
      This is an example of maturity transformation: Dana incurs a short term liability, credit card debt, to fund the acquisition of a long-term asset, better job skills. It can result in a bank-run-like phenomenon if her credit card lender becomes fearful of her ability to repay and stops lending to her. If this happens, she will not be able to finish her course and, as a result, will not be able to get the better job that would allow her to pay off her credit card loans.

    • Question

      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
      This is not an example of maturity transformation because there are no shortterm liabilities. So it is not subject to a bank run. The partnership itself has no obligation to repay an individual partner’s investment and so has no liabilities, short term or long term.

Solutions appear at back of book.