As we learned in earlier chapters, banks perform an essential role in any modern economy. In Chapter 14 we defined commercial banks and savings and loans as financial intermediaries that provide liquid financial assets in the form of deposits to savers and use their funds to finance the illiquid investment-spending needs of borrowers. Deposit-taking banks perform the important functions of providing liquidity to savers and directly influencing the level of the money supply.

Lehman Brothers, however, was not a deposit-taking bank. Instead, it was an investment bank (also defined in Chapter 14)—in the business of speculative trading for its own profit and the profit of its investors. Yet Lehman got into trouble in much the same way that a deposit-taking bank does: it experienced a loss of confidence and something very much like a bank run—a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Lehman was part of a larger category of institutions called shadow banks. Shadow banking, a term coined by the economist Paul McCulley of the giant bond fund PIMCO, is composed of a wide variety of types of financial firms: investment banks like Lehman, hedge funds like Long-Term Capital Management (LTCM), and money market funds. (As we will explain in more detail later, “shadow” refers to the fact that before the 2008 crisis these financial institutions were neither closely watched nor effectively regulated.)

Like deposit-taking banks, shadow banks are vulnerable to bank runs because they perform the same economic task: maturity tranformation, the transformation of short-term liabilities into long-term assets. From now on, we will use the term depository banks for banks that accept deposits (commercial banks and savings and loans) to better distinguish them from shadow banks (investment banks, hedge funds, and money market funds), which do not.