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-
Lehman Brothers, however, was not a deposit-
Like deposit-
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—
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-
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—
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—
Maturity transformation is the conversion of short-
More generally, what depository banks do is borrow on a short-
A shadow bank is a nondepository financial institution that engages in maturity transformation.
Instead of taking deposits, Lehman borrowed funds in the short-
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-
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-
To prevent such occurrences, after the 1930s the United States (and most other countries) adopted wide-
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–
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 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 in lower Manhattan. 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 14, 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.
In July 2008, Lehman reported a $2.8 billion loss for the second quarter of 2008 (the months April–
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.
There is a trade-
Banks allow savers to make a superior choice in their liquidity–
Since 1980 there has been a steady rise in shadow banking because shadow banks—nondepository financial institutions that engage in maturity transformation—
Because shadow banks, like depository banks, engage in maturity transformation, they can also be hit by bank runs. Shadow banks depend on short-
Which of the following are examples of maturity transformations? Which are subject to a bank-
You sell tickets to a lottery in which each ticket holder has a chance of winning a $10,000 jackpot.
Dana borrows on her credit card to pay her living expenses while she takes a year-
An investment partnership invests in office buildings. Partners invest their own funds and can redeem them only by selling their partnership share to someone else.
The local student union savings bank offers checking accounts to students and invests those funds in student loans.
Solutions appear at back of book.