The world’s financial authorities have rightly been doing whatever it takes to limit the fallout of one of the worst pandemics ever. Central banks — particularly the U.S. Federal Reserve — have devised unprecedented measures and pledged trillions of dollars to support lending. Their efforts have eased panic, stabilized markets and kept at least some money flowing to people and businesses.
Yet this episode, much like the last crisis in 2008, raises a troubling question: Why is the financial system so fragile that, whenever something big and unexpected happens, the world must rely on officials’ heroic efforts to rescue an ever-widening array of markets and institutions?
When the economy gets back on the path to recovery, it’s worth considering whether a more permanent fix is needed.
The system’s vulnerability stems from a defining element of banking. On one side of their balance sheets, banks issue short-term debt such as deposits — promises that people can access their money immediately or on short notice. On the other side, they put most of the money into longer-term investments such as loans. Generally, this works fine: Banks keep enough cash on hand to facilitate their customers’ needs, and their lending helps fuel economic growth. But at any given moment, banks have the cash to pay only a fraction of their depositors. So at the slightest sign of distress, people have a strong incentive to get their money out first — triggering “runs” that can devastate the financial system and the economy.
Central banks exist to address this vulnerability. The Fed stands ready to lend banks as much cash as they need to meet withdrawals in an emergency — as long as they have assets to pledge as collateral. This lender-of-last-resort function — alongside federal deposit insurance — is designed to alter depositors’ incentives. If they’re confident that they can get their money, there’s no need for a run in the first place.
For much of the 20th Century, from the New Deal on, this arrangement operated smoothly. The issuance of runnable liabilities — in this case deposits — was limited to chartered banks, which invested primarily in straightforward mortgage and commercial loans. The central bank had a reasonable grasp of how much short-term debt it was backing, and what collateral stood behind it. No systemic runs occurred, even during the rash of savings-and-loan failures of the 1980s and 1990s.
As often happens, though, a long period of calm created the conditions for its own undoing. Beginning in the 1980s, officials allowed a parallel, “shadow” banking system to emerge, largely outside the Fed’s purview. Money market mutual funds, for example, competed with bank deposits by offering shares that could be redeemed on demand for $1 (and paid higher interest). The funds invested shareholders’ cash in other short-term obligations, such as commercial paper and “repo,” which entailed making loans — typically overnight — against the collateral of securities. Other non-bank financial institutions — including broker-dealers, hedge funds and various conduits — used such financing to build large holdings of securities backed by assets such as commercial, auto, credit-card and mortgage loans. Specialized finance companies, as well as banks, originated the loans.
All this innovation vastly expanded the financial system’s dependence on short-term debt, issued by entities not subject to the safeguards that apply to deposit-taking banks — such as capital requirements, federal insurance and explicit access to emergency loans from the Fed. By 2007, the gross amount of three major types of non-deposit short-term obligations in the U.S. — money market shares, commercial paper and repo — had risen to $8.8 trillion, or 60% of the country’s annual economic output. That was up from about $50 billion, or 5% of GDP, in 1970.
The transformation fueled a credit boom: In the U.S., total credit to companies and households increased nearly 70% from 1980 to 2007. Unfortunately, it also left the system more vulnerable to runs. If a single link broke — if people pulled cash from money market funds, or if repo malfunctioned — the whole supply chain of credit could fall apart.
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