To prevent financial crises, regulate short-term debt

By Roberta Kwok

The financial crisis of 2007-2008 took economists by surprise. Prior to this, the United States had not experienced a major crisis since the Great Depression. “There was this rash assumption that we wouldn’t have one,” says Gary Gorton, finance professor in the Frederick Frank Class of 1954 at Yale SOM. “They said, don’t worry about it.”

So why did the banking system collapse? Contrary to popular narrative, the reason was not simply greed, Gorton argues. “There is an inherent problem in the banking sector,” he says. “And the inherent problem has to do with the nature of their debt.”

Read the study: “The regulation of private money”

One of the functions of banks is to issue short-term debt, which means the lender can get their money back usually in a week or less. For example, when a customer deposits funds in a current account, he lends money to his bank. She can get this money back whenever she wants by withdrawing cash or writing a check. As Gorton explains in a new article, the price of short-term debt is fixed. If a customer writes a check for $100, the recipient accepts that the check is worth $100 and does not dispute its value.

Before the 2007-08 crisis, a kind of short-term debt called the market for sale and repurchase (repo) agreements became popular. The process worked like this: A large lender, such as Fidelity, wanted to store money overnight and earn interest. So Fidelity lent, say, $500 million to an investment bank like Goldman Sachs. To assure Fidelity that its money was safe, Goldman Sachs provided a guarantee.

With short-term debt, Gorton says, “no one is going to produce information about what’s supporting that debt.” The lender does not have time to analyze the collateral in detail. “That guarantee should be something that Fidelity just takes, no questions asked,” he says. In the repo market, debt was often backed by securitized bonds, created by pooling income-generating assets like mortgages.

The problem comes when lenders start to question the value of collateral, as they did in 2008. “Everyone thinks, oh wait a minute, this collateral is no good,” Gorton says. Since the price is fixed, the only factor that can change is the amount lent. In other words, lenders stop lending money to banks, cutting off their cash supply – essentially, a bank run. “If you’re Goldman Sachs and you’re 50% funded in the repo market, and the day comes when lenders decide they don’t want to lend to you anymore, then you have a really big problem,” Gorton says. . Banks were forced to sell assets and prices fell.

Regulators have tried to prevent such crises in two ways. One requires that short-term debt be backed by high-quality collateral. However, “it’s a system that has never really worked successfully,” says Gorton.

For example, the US National Banking Acts in the 1860s required national banks to back their money with US Treasury bonds. But treasury bonds were in short supply because other companies wanted them too. Thus, a shadow banking system developed, in which checking accounts were backed by loan portfolios. Whenever customers worried about the stability of their bank, they lined up to get their money back, causing frequent crises over the next half-century.

To avoid a repeat of 2007-08, “you need to know what exactly is causing the crisis,” says Gary Gorton. “And that means understanding what exactly a bank is.”

In 1933, the United States instituted nationwide deposit insurance, which meant that the government would support the banks. It worked from 1934 to 2007, “which kind of lulled people into this false sense of security,” Gorton says.

So what happened in 2007? Although the repo market was a form of short-term debt, it was unsecured. “Nobody considered it part of the bank,” he says.

Regulators need to find all types of short-term debt, measure them and impose collateral, Gorton says. Some short-term debt may be issued by companies that are not considered banks. “But if a company issues it, it’s actually a bank,” he says. “And it’s vulnerable to races because, by design, the price is fixed.”

But short-term debt regulation is not the only answer. If a bank, that is, an organization that issues this type of debt, does not like the rules, it can simply migrate to an unregulated shadow banking system.

So how can banks be kept in the regulated system? The answer lies in their charter value, Gorton says. Setting up a bank requires a license, and the license allows the company to obtain deposit insurance. Licensed banks have local monopolies and thus reap additional profits, he says. Charter value is the value of these monopoly profits.

“The way you keep banks in the banking system is you allow them to have charter value,” he says. “Then they want to be a bank, and they don’t want to risk losing their precious monopoly license.”

Paying attention to these issues is key to preventing further financial crises, Gorton says. To avoid a repeat of 2007-08, “you need to know exactly what is causing the crisis,” he says. “And that means understanding what exactly a bank is.”