Without banks, people would make the trade-
Shadow banks have grown greatly since 1980. Largely unregulated, they can pay savers a higher rate of return than depository banks. Like depository banks, shadow banks engage in maturity transformation, depending on short-
Although banking crises are rare, they typically inflict severe damage on the economy. They have two main sources: shared mistakes, such as investing in an asset bubble, and financial contagion. Contagion is spread through bank runs or via a vicious cycle of deleveraging. When unregulated, shadow banking is particularly vulnerable to contagion. In 2008, a financial panic hit the United States, arising from the combination of an asset bubble, a huge shadow banking sector, and a vicious cycle of deleveraging.
The United States has suffered numerous banking crises and financial panics, each followed by a severe downturn. The crisis of the 1930s spurred bank reform that prevented another crisis until 2008. Banking crises occur frequently throughout the world, mostly in small, poor countries. In the recent past, though, several advanced countries have had banking crises driven by real estate bubbles.
Severe banking crises almost invariably lead to deep and long recessions, with unemployment remaining high for several years after the crisis began. There are three main reasons why banking crises are so damaging to the economy: they result in a credit crunch, the vicious circle of deleveraging leads to a debt overhang, and monetary policy is rendered ineffective as the economy falls into a liquidity trap. As a result, households and businesses are either unable or unwilling to spend, deepening the downturn.
Unlike during the Great Depression, governments now step in to try to limit the damage from a banking crisis by acting as the lender of last resort and by guaranteeing the banks’ liabilities. Sometimes, but not always, governments nationalize the banks and then later reprivatize them. In an extreme crisis, the central bank may directly finance commercial transactions.
Economic damage from the financial crisis of 2008 was large and prolonged. The world’s two largest economies, the United States and the European Union, suffered severe downturns, shrinking more than 5%, followed by relatively slow recoveries. The persistence of economic difficulties after 2008 led to fierce debates about appropriate policy responses between economists and policy makers calling for more fiscal stimulus—
The banking regulatory system put in place during the 1930s has eroded due to the rise of shadow banking. The dependence on short-
The crisis of 2008 began as the shadow banking sector suffered high losses when a real estate bubble burst. Despite the fact that governments and central banks around the world stepped in to fight the crisis and the downturn, most advanced countries experienced their worst slump since the 1930s. Persistently high unemployment is likely to endure for years to come.
In the aftermath of the crisis, the U.S. Congress enacted the Dodd-