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.

Imagine that you live in a world without any banks. Further imagine that you have saved a substantial sum of money that you don’t plan on spending anytime soon. What can you do with those funds?

One answer is that you could simply store the money—say, put it under your bed or in a safe. The money would always be there if you need it, but it would just sit there, not earning any interest.

Alternatively, you could lend the money out, say, to a growing business. This would have the great advantage of putting your money to work, both for you, since the loan would pay interest, and for the economy, since your funds would help pay for investment spending. There would, however, be a potential disadvantage: if you needed the money before the loan was paid off, you might not be able to recover it.

It’s true that we asked you to assume that you had no plans for spending the money soon. But it’s often impossible to predict when you will want or need to make cash outlays; for example, your car could break down or you could be offered an exciting opportunity to study abroad. Now, a loan is an asset, and there are ways to convert assets into cash. For example, you can try to sell the loan to someone else. But this can be difficult, especially if you need cash on short notice. So, in a world without banks, it’s better to have some cash on hand when an unexpected financial need arises.

In other words, without banks, savers face a trade-off when deciding how much of their funds to lend out and how much to keep on hand in cash: a trade-off between liquidity, the ability to turn one’s assets into cash on short notice, and the rate of return, in the form of interest or other payments received on one’s assets. Without banks, people would make this trade-off by keeping a large fraction of their wealth idle, sitting in safes rather than helping pay for productive investment spending. Banking, however, changes that by allowing people ready access to their funds even while those funds are being used to make loans for productive purposes.

Banking, as we know it, emerged from a surprising place: it was originally a sideline business for medieval goldsmiths. By the nature of their business, goldsmiths needed vaults in which to store their gold. Over time, they realized that they could offer safekeeping services for their customers, too, because a wealthy person might prefer to leave his stash of gold and silver with a goldsmith rather than keep it at home, where thieves might snatch it.

Someone who deposited gold and silver with a goldsmith received a receipt that could be redeemed for those precious metals at any time. And a funny thing happened: people began paying for their purchases not by cashing in their receipts for gold and then paying with the gold, but simply by handing over their precious metal receipts to the seller. Thus, an early form of paper money was born.

Meanwhile, goldsmiths realized something else: even though they were obligated to return a customer’s precious metals on demand, they didn’t actually need to keep all of the treasure on their premises. After all, it was unlikely that all of their customers would want to lay hands on their gold and silver on the same day, especially if customers were using receipts as a means of payment. So a goldsmith could safely put some of his customers’ wealth to work by lending it out to other businesses, keeping only enough on hand to pay off the few customers likely to demand their precious metals on short notice—plus some additional reserves in case of exceptional demand.

And so banking was born. In a more abstract form, depository banks today do the same thing those enterprising goldsmiths learned to do: they accept the savings of individuals, promising to return them on demand, but put most of those funds to work by taking advantage of the fact that not everyone will want access to those funds at the same time. A typical bank account lets you withdraw as much of your funds as you want, anytime you want—but the bank doesn’t actually keep everyone’s cash in its safe or even in a form that can be turned quickly into cash. Instead, the bank lends out most of the funds placed in its care, keeping limited reserves to meet day-to-day withdrawals. And because deposits can be put to use, banks don’t charge you (or charge very little) for the privilege of keeping your savings safe. Depending on the type of account you have, they might even pay you interest on your deposits.

More generally, what depository banks do is borrow on a short-term basis from depositors (who can demand to be repaid at any time) and lend on a long-term basis to others (who cannot be forced to repay until the end date of their loan). This is what economists call maturity transformation: converting short-term liabilities (deposits in this case) into long-term assets (bank loans that earn interest). Shadow banks, such as Lehman Brothers, also engage in maturity transformation, but they do it in a way that doesn’t involve taking deposits.

Instead of taking deposits, Lehman borrowed funds in the short-term credit markets and then invested those funds in longer-term speculative projects. Indeed, a shadow bank is any financial institution that does not accept deposits but does engage in maturity transformation—borrowing over the short term and lending or investing over the longer term. And just as bank depositors benefit from the liquidity and higher return that banking provides compared to sitting on their money, lenders to shadow banks like Lehman benefit from liquidity (their loans must be repaid quickly, often overnight) and higher return compared to other ways of investing their funds.

A generation ago, depository banks accounted for most banking. After about 1980, however, there was a steady rise in shadow banking. Shadow banking has grown in popularity because it is not subject to the regulations, such as capital requirements and reserve requirements, that are imposed on depository banking. So, like the unregulated trusts that set off the Panic of 1907, shadow banks can offer their customers a higher rate of return on their funds. As of July 2007, generally considered the start of the financial crisis that climaxed when Lehman fell in September 2008, the U.S. shadow banking sector was about 1.5 times larger, in terms of dollars, than the formal, deposit-taking banking sector.

As we pointed out in Chapter 14, things are not always simple in banking. There we learned why depository banks can be subject to bank runs. As the cases of Lehman and LTCM so spectacularly illustrate, the same vulnerability afflicts shadow banks. Next we explore why.

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 relatively good 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.

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.