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e l ! , i v c .u i s e o : " : [ s ; i n d r i - s L ;n d a h :e c i s ! , i s r e All :nall. Sow ell o t i e i s ,i l u n i i h e ' ol deavv e-^vl n i i i c i a m i c iAe n n o n o ' n en ^h! o r w , i ! : , i . k c d : h c v . k : ;o : ' c h i I h t i e : CAVA \ a- : o- an ^ :de,i >-: : ; : e h o o ; ^ ! n : ; h e k a ^ e - r\\u .. n-, ; ; n p : - . ssk n :oo. and i: e - o n c o ' 'A iier, he > iH ,k : h^r. i- ' , \ \n.Kecaieo [o o m.u i " . ' oi n u n i onk\ pai ; i \ d e \ r i o : \ ' c [ lie nu'Si ma e r e s : ; no, MA i i ipo i lan: iceas

Si> win i\o I Imd [Ml-, seeikni o I the . invj defended ( 'n e t m a l e \ a t i i p i e . ,Sowel m lus i > o i i k . I ' i i l o i i i i n . K e h " , he^..n es ik'hook 'Aeakr : Sceau se Sow el ! i> q n i i r sc iee- J , i n n s t h a i : ho-.e o: us 'A l i o \A\ '^ '^: i et e\ i t eni : !o i rha: , "on i : \ i r i - ;on i'c.r ; iookiA'.'c 111 \'.]-- I L W i n K K k : : o! h;--to: \ ( o ie ' ider n i , i : ke[s are n io : c em pa i. .sli'i i;k"!inev'' A : ' . ' . \ v \ o i ; , i ! ha\e heer .ie. 'e. i : l o v j i n in \\nich toi;is kaM,"i,\-.uin o\ \ \ ' : [~am. Me le.uls o\: h.e.e iess . 'op \:]\ i,-\i^-c. ai osa ', lew s [h .m .lo so [ A I oii [h,s k:e.i .ni d n ' o nairc o rh -\^ l h i ns t o i h i ; seiH e n e e : : nose w h o , id \Oi . I I L ' eei i i i 'a l p L i n n n i i : ; ,uid ers, li e l iM\es h is readei s Linsa[i'-t l e d . E3

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." i .e . J l , 11In,-i";i l i o : n ci i]>_: oi i i . |ni - i i ' i l I", ] ^^^ \c:\ , i : i J i - r i : , H . " p i w i i v m K f ^ a ! . ; : ' ! " ! . \ . . . [ > . \ , ^n p . i p r i ' - i h j ; d e n . n , \ ) : i s i n ! d i . , n ; d r ^ c r " , ;N ' i ' i -! h \ " ' r : - : . i i r . . ( o r i i e c : - s[ - , . p , . | \ i ^ ^ , i - c ' ( v i i ; s o e i . . t . o - c : I P o - ^ r - -; v v n h l ' i i ' O ' >: i , , ' ' . ' r .! ; ! ! > - l ' e i l v " i d . d " ' - -- ' " ' ' ' " " ' ' ' ' ' " ' ' ' ' " i l -'"* o i e , a ! ' ! . , , _ , ,,,, , , . i : v . . i ; ;; . 1 1 ^ , ^ ; ; ^ j J ; v , || - . ; : e X . - - , . ' r n i , - : \ a > o - . d u e i h i ' i. .. : a . n [ a [ ; e ; : - , > ; P V D

Shadow Banking and thenancial Crisis

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A:ie] ' [ li,![, Sou ci l pj'es on [o kn o'at I VT^ " -sni"|M ;sinel\, niai i \ ol [h e mua - seeinai i/e.l loans, i lie '\le;"'o-.i[o:-s" n i l ieihc --p'-olks ot ho',\ : ! . / ,iiir:'C'a! move- X N es[:ini: pap-, rs [ l: .^i s:nv.il'.;ncn[ a; dh-1 r\ii\: Si .ncs lei;\'.: -.w^.i' :) : h,e:r n'one\.v.a\ [or Cele a r m \ le i nam. 1am noi uasis [ lia\'c leai neu* m ik h l i on i ihc \\oi k Pi lo i :ii ihe J(K)S L ash, dep.^Miors n:enoihh o cai exper: on \ k'in.iii"; i.> kn.^w" ,>l < ' . A V X (H^ :on , :'!otessoi ot I n.ir.ee a i lie ! :ie .^h.klow !\inknk,; s\s:em : raded eash'.v:iethc: So\',cd is.>\i :si:np,;tv a^e. !a:r [ 'tdk School ol \kinaL_;cmein. Hcan.nk's :o[ ecinn!/L\ k \ n \ ot i\].;:\ d;ai: rC-Cek:ikv>i, ,'[\s h' ,, i Cshoui i h c i or k ;o [.^kiw, [h.i; a \ast sh.kiow l'anknke, sesrem nas v,;l;-e aki l'eonived :;;e in\ c^:[nen: h . I I K [o[ h.U '.Ml 11 his I rsL v\' words ;n l\\r a h ow ile'Cr k^jwl over :1k' kisi lu ve.un mi rsi dc :1k' se aside \\'r\ litlic v^i l^r' .oll.er.i! .isl; o:ouo[e , So.>. ell a'coids lk m.r'or isMk" duj ir ,ki mon a! ieoul.Kei.1 !\u: ki no svsu'iii ot ca-:i,;i ih,u isno: lo,ned oiip. 1 liai is, S 1,[ n-:.ikt' -.a'-.e ro i :;ic ,::[cd Sna^-s Oi.\ - eo\\-nmc:[aik cii.iMcri'd ae.[::i::ions [h.ii i i i i laoi ; in ,.isn \oi-. i ; avie.i :o r ^I in;!ho:;e i :n i k 'n i n-inter-, ciu m \ ,er:",ani;'W : ia: ai. Ci p[ deposHs and m . I M - ioaiis, ,\s oi ir, se. ; i : - ; ; i/ed l.i.wis, oicanse deposUkiisil [h e deiiuMHs exceeded th.e inerKs, as JiKI"', [wo-di i rds ol L.',S, iendm.j; was m dioni;,hi ot'the s.'i i io:'i rnnclies o| si-eun-man'c ,\nk-: k"a:!s nchionv^ nse, oin;e [o U'.- sh.aiknv n.inknk^ s'cstia:: ,inii on b, one- ii/cd loans ,is s;r,"n : s. te," I'A Novcmde:'iv inainei i si lc:!; :" Mow didde:ir,se oi In ihe slh kjou dank ine, s-.seciii M I S O hjcausc diposri,^^ le.ued--ecia in/CkMoa:^Ai iie rk a niipK' (li.ii [ ie 1 ,S, JJOVL'I n ni en t called :h e "o\'ei i iu;h: repiiu ii.ise" or '"repo" losses Ih.i; sami~ Si mils ion m iash. veassh.\:.d ;,;e! iir.oAevi a:.sn Asian i I M I \'..ir make: corjvii atioiis, eoxci rmeius, . r i d [rade.: to i S ! mil ; 'on a; seen: :: i/ t\] ioain-,ll!Ot:-^an>|s ot inns .iwav ' I )ocs [ ma:! er in \es[, ir s denos a e.,!' hc. indH'i,is ot nnl in i l w i : ; : .i;advki;.\iai cjiai-emee: d",:lo >o\wk o\' Ca''C-. he tV v>n know ih,u lieis o! kioli.!: s ove; ni..^h: m[lie equivalen: S5(),0ni i hesei as;.;, i;-,easn . r .a["Uak,m Anii ': 'ie,!n pi'esideiu. I)\vu^h[ I isen- ol i '\;ieme!\ la;y,i' inone\'iii.irki'[ aceouiiis, Ihese so i alk\i "haneiKs" sewreK' leJueed,;.>'.'eei :M I - ] \eiK\: m h*. 1uihelp set np ;n\es!ei.; ;n-,,. n:i:i/ee! k\;ns lorcai's, hinis- th o '.endan; akili:\ ot :d c S K K I O W kankinca ;>". : ; i ;n-/n: mSo;i: c \ ktncaii ;n v:o-,a- e >, .m,: con se iik' ;' .;eda. Wne ii : ;ns sn,k' s'.; .M:; ,;-, ,/ert,ir;a,ns' l ' inx 'celaied hankin,; n. suh-quesrioi iswidi i l ;.casca; Wliaiev e i ; lie peter van Doren . - o , ' . . - . ^ ^ ^ iec: [o>.;,, k - n :> h i . : eo\ er:Mncn[-'n.u-

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I N R E V I E Wbanking eliminated them. But large cor-porate checking accounts were uninsuredand received no interest within thepost-New Deal regulated bankin g system.Markets thus responded with the shadowbanking system. This provided incomefor large corporate and investor demanddeposits that funded loans for consumersat lower cost than the regulated bankingsystem. For more t ha n 30 years, this mar-ket response appeared to be "good" arbi-trage around the expensive regulatedbanking system. But then a large runoccurred in the shadow banking systemand the Federal Reserve responded bybecom ing a lender of last resort to all themarkets abandoned by "depositors" in theshadow banking system.

Insurance or Narrow Banking? Twopolar o pposite policy responses have beenproposed to avoid future "shadow bankruns." The first proposed response, called"narrow bank ing," has been advocated byLarry Kotlikoff, Oz Shy, and A mar Bhid,among others . Narrow banking is anattempt to carefully demarcate the differ-ence between th e paym ents system (check-ing accounts, passbook savings, and otherdemand deposits) and all other invest-ment. Money in the payments systemwould be fully backed by cash or treasur-ies. All othe r investment w ould be at-risk.The second proposed response is theextension of the current safety net to alldemand deposits, along with restrictionson financial activities. That would bringthe shadow banking system back withinthe regulated system, extending depositinsurance to overnight repo and moneymarket mutual funds.

Both of these "solu tions" have logicalflaws. The problem with narrow bankingis the time inconsistency of governmentpolicy. Fannie M ae an d Freddie Mac wereno t legally backed by the government, norwere money market funds, nor overnightrepo. But when the system canie undersevere financial stress, the governmentchanged the policy. Likewise, if futurestress were to hit at-risk deposits, placingthe broader economy in jeopardy, theWhite House and Congress would surelyride to the rescue again and investorsknow that. So what would stop investorsfrom taking on higher-than-appropriaterisk if they know ^yashington stands ready

with bailout money?The second problem with narrow

banking is that it would require the legalsuppression of what most people now callbanking, i.e., financial intermediation inwhich shor t- term depos i ts are t rans-formed into longer- term inves tment .Banks a rise naturall y in a free society, andthe narrow ban king regime would requirethe use of the power of the state to sup-press the t ransformation of demanddeposits into investment

Morgan Ricks, a U.S. Treasury official,has written an impor tant paper tha t takesGorton seriously, recognizes the time incon-sistency involved in the narrow bankingsolution (the state cannot precommit notto help at-risk investment), and advocatesthe second solution: deposit insurancemust be provided to all demand depositsand lending entities, subject to capitalrequirements and activity restrictions. Heagrees with Go rton t hat b anks (and shad-ow banks) strive to create info rmationallyinsensitive deb t financial obligations tha tare unlikely to be upset by news (good orbad). This is in contrast to equity and cor-porate bonds, which are informationallysensitive stock and bond prices fre-quendy change as news comes in. Infor-mationally sensitive financial instrumentstrade in the secondary market, and marketactors expend resources to inform theirdecisions abo ut buying and selling stocksand bonds. In contrast, loans to business-es and individuals from traditional ba nksand securitized loans in the shadow bank-ing system do n ot trade in secondary mar-kets, and n o one outside the original lenderattempts to gather information about loanrepayment probability.

When circumstances conspire to makeloans in the traditional bank ing system orsecuritized loans in the shadow bankingsystem informationally sensitive, deposi-tors and repo investors respond bymakinga run on the bank. The threat of a runcould impose market discipline, incen-tivizing banks and shadow banks to do agood job in creating informationally insen-sitive debt, and giving opportunities toentrants to profit from picking up thepieces if a ba nk falls. Bu t ru ns w ould haveto be allowed by government in order toenforce tha t discipline and provide tho seopp ortun ities. Since the Depression, gov-ernments have not been willing to run

that experiment. So we do not knowwhethe r the Federal Reserve's creation oall its lending facilities, which replacerepo and su pported securitized asset lending during the crisis, occurred more quickly an d effectively th an p riva te fac ilitiewould have. And go ing forward, government cannot credibly commit to allowthe experiment to occur.

Ricks modifies (in my opinion , correcly) the Gorto n view that the shadow banking system developed simply to meet thexogenous needs of large dema nd depostors who wanted to arbitrage around thexpensive traditional banking system. ThGorton view may have been true initiallybu t the increasing flow of funds from thtraditional to the shadow bankin g systemwas the result of an endogenous feedbacloop. The greater the use of short-termrepo, the more dam aging a panic of thoscreditors would be and the more likely thagovernment would provide a bailout if panic were to occur. Thu s the likelihood a bailout is an increasing function of thoverall qua ntity of liabilities t ha t are potentially subject to p anic. Put simply, shadowbanking creates more shadow banking anincreases the likelihood of a run and subsequent federal intervention, so one mighas well return to the old system an d havexplicit governm ent assistance ex an te (i.edeposit insurance) accompanied by ruletha t constrain lending behavior. The diffculty, of course, with a regulated deposinsurance world for all dem and deposits the misma tch between the potential fedeal Uabit)' of trillion s o f dollars (the totaamo unt of money in the current bankinand shadow banking systems) and the actual federal resources available, as well as thneed to suppress arbitrage aro und the regulated system.Bankruptcy An impo rtant modificatioto the Gorton-Ricks thesis comes fromMark Roe, professor of law at Harvard. Hargues that the use of overnight repos anderivatives, the hea rt ofth e shadow banking system, was endogenous, as Rickargues, bu t no t simply because ofthe inabiity of the political system to precommnot to bail out short-term creditors. Insteaimp ortant changes in the bankruptcy codtha t C ongress enacted to prevent systemirisk actually encouraged it. The changegave priority to repos and derivatives i

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the ban kru ptq ' process, which encouragedthe use of such instruments and led to alack of concern by repo owners about thequality of assets swapped for overnightcash. Th at is, the informational insensidv-ityof the repurchase agreements describedby Gorton and Ricks was the result of theprivileged position held by such invest-men ts at the head of the bankrup tcy line,which insured full reimbursement. ThusRoe argue s th at th e ever-increasing relianceon s hort-term repurchase agreements wasthe result of bankruptcy poHcy changes.And the bankruptcy priority made runsthe rational response of participants in theovernight repurchase market.

Roe argues th at all creditors should betreated identically in bankruptcy. Thiswould increase market mon itoring by thesuppliers of deposits on investment anddecrease the use of short-term funds toback longer-term investment.House Prices At the roo t of the financialcrisis was a steep reductio n in the value ofhomes in many housing markets and theresulting defaults on mortgages whoseface value gready exceeds the reduced mar-ket value of the hom es on which they arewritten. Some have argued that the steeprise an d fall in prices is sufficient to con-clude that housing supply constraints aris-ing from zoning restrictions are the m aincause of the ho using bubble, and that thecurrent focus of the media a nd political sys-tem on easy mortgage availability ignoresthe real regulatory problem.

Thomas Davidoff, an economist at theUniversity of British Columbia businessschool, has written a paper that attempts todetermine the importance of demandincreases and supply constraints in therecent housing bu bble. He does so by com-paring house price behavior in what hecalls "coastal" metropolitan areas (thoseareas with low supply growth and largeprice appreciation in the 1980s, fromBoston to New York and Califomia) d uringdie 2004-2007 bubble and the 2007-2009crash with a "comparison" group of met-ropolitan areas (those areas with large sup-ply growth and low price appreciation inthe 1980s), The appreciation from 200 4 to2007 and depreciation from 2007 to 2009were not significandy different in coastalversus comparison groups. Thus, metro-politan areas with a history of low price

and large supply appreciation in the pasthad aboom -and-bust pattern in the 2000s'tha t did not differ from m etropolitan areasthat had a history of the o pposite. This lackof difference in pricing behavior castsdou bt on the role that supply constraints(natural or regulatory) played in the h ous-ing bubble.

It is possible that the supply in thecomp arison areas changed from elastic toinelastic between the 1980s and 2000s,throwing off DavidofPs test. He checkedfor this by calculating the ratio of h ousinguni ts permi t ted in each metro a reabetween 1998 and 2007 with the unitspermitted between 1980 and 1990, andthen determined whether the ratios weredifferent in the coastal and comparisoncities. There was no significant supplychange in the co mparison cities, evidenceconsistent with a demand-driven ratherthan a supply-constrained housing b ubble.

A recent paper by the New York Feder-al Reserve corroborates the role tha t n on-traditional m ortgage instrumen ts playedin augmenting housing demand. Acrossmetropol i tan a reas , the cor re la t ionbetween nonprime loans per 1,000 hous-ing units and 2000-2006 housing priceappreciation was 0,64, And across metro-politan areas the correlation between non-prime loans per 1,000 housing units and2006-2008 housing price depreciationwas 0.75. "Why might this correlationhold?" ask the authors. "It is likely thatcausation runs in both directions anincrease in non prim e lending led to moresignificant home price appreciation, andmore rapid ho me price appreciation led toa rise iti nonprime lending,"Foreclosure Assistance Many haveargued for foreclosure assistance modeledon th e New Deal-era Home O wners LoanCo rpora tion (HOLC), which refinancedshort-term mortgages into long-term, low-interest , amortizing mortgages. Whateffects did HOLC have? In theory, suchassistance shou ld have increased dem andfor and probably the supply of owner-occupied housing and reduced demandfor and maybe the supply of rental hous-ing. But did that in fact happen?

In an im po rtant new paper. Price Fish-back and colleagues regress 1940 ho usingdata against 1933-1936 per-capita HOLCfunding. Their initial regression finds

increased hom e ow nership as a result of theprogram . But the ad dition o f control vari-ables for differences that varied acrossstates and time, as well as the fact thatHOLC funding was no t rando m (morefunding went to troubled housing mar-kets), reduces the effect of HOLC to zero.The effects were positive in counties withless than 50,000 people, but that resultarose from the lack of integra tion betweenrural and national lending markets in the1930s. These results suggest great cautionin using HOLC as an example of the posi-tive effects t ha t foreclosure assistance canhave on hous ing markets. 13Readings "Bankruptcy's Financial Crisis Accelerator:The Derivatives Players' Priorities in Chapterl l , " by Mark Roe, March 2010, Availableat http://papers,ssrn,com/sol3/papers.cfm?abstract_id= 1567075, "Bypassing the Bust: The Stability ofUpstate New York's Housing Markets du ringthe R ecession," byjais on R, Abel and RichardDietz, Current Issues (Federal Reserve Bank ofNew York) Vol. 16, No, 3 (March 2010), "In Praise of More P rimitive Finance," byAmar Bhid, The Economists' Voice, Vol, 6, No,3 (February 2009), "Limited Purpose Banking Putting anEn d CO Financial Crises," by ChristopheChamley and Laurence J, Kotlikoff, FinancialTimes, Janua ry 27, 2009, : "Restoring the Banking Social Contract,"by Morgan Ricks, March 2010, Availableat http://papers,ssrn,com/sol3/papers,cfm?abstract_id= 1571290, "R ethinking the Roles of Banks: A Call forNarrow Banking," by Oz Shy and RuneStenbacka , The Economists' Voice, Vol. 5, No, 2(February 2008). "Securitized Banking and the Run onRepo," by Gary Gorton and Andre Metrick,January 2009, Available at http://papers,ssrn,com/sol3/papers,cfm?abstract_id= 1440752, "Slapped in the Face by the Invisible Hand:Banking and the Panic of 2007," by Gary Gorton, Presented at the Federal ReserveBank of Atlanta conference on financialmarkets. May 11-13, 2009, Available athttp://papers,ssrn,com/sol3/papers,cfm?abstract_id= 1401882, "Supply Elasticity and the Housing Cycle ofthe 2000s," by Thom as Davidoff March2000, Available at http://ssrn,com /abstract= 1562741, "The Influence of the H ome Ow ners' LoanCorporation on Housing Markets during the1930s," by Price V, Fishba ck, Alfonso Flores-Lagunes, William Horrace, Shawn E, Kantor,and Jaret Treber, NBER working paper No,15824, March 2010,

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