What Caused The Great Financial Crash: Gary Gorton Is Right

15 january 2013

As you will have noticed there’s still a certain amount of shouting going on about what precisely caused the Great Financial Crash of 2007/08. Explanations run from some explosion of greed in the banking classes through massive deregulation of finance to increasing inequality and even, in some of the more bizarre diagnoses, an insistence that this is just late stage capitalism and the communist nirvana is soon to be at hand.

The thing is there’s a much simpler explanation for what happened. A much simpler explanation that has the great merit of actually being correct. David Warsh over at Economic Principals lays it out in somewhat technical language. But the basic point is that Gary Gorton is right.

Leave aside all of the more complicated explanations. Look purely at what fractional reserve banking itself is. You put your money into a bank and the bank then lends it out to someone else. They have a spread on the interest rate they charge the other person over what they pay you and this pays for the buildings, the unpaid loans, the staff and everything else. So far so simple but we need to add two more little facts here: only two more and we can explain what happened.

The first is temporal arbitrage between the preferences for saving and lending. Which is such a mouthful that it doesn’t really explain anything. What it means is that people tend to want to borrow money for longer than they want to save it. If I go and borrow money for a mortgage then I want to borrow that money for 30 years. But you, putting your money on deposit at the bank, don’t want to leave your money there for 30 years so that I can borrow it. You might just be saving for your vacation in the spring. Or for a deposit for your own house in a year’s time, or even just so that you’ve a little spare cash to deal with any of life’s little emergencies. So, what a bank actually does is borrow short and lend long: Brad Delong has used this as a definition of a bank. If you do this you are a bank and if you don’t you’re not. The bank borrows from depositors from on demand (our checking accounts) up to perhaps 90 days (CDs perhaps). But it will usually be lending for some years to some decades: borrowing short and lending long. The bank relies on the idea that there will be a continual stream of those short term deposits with which it can finance those much longer loans.

If all the money is lent out in this manner then there’s no way that we could get out money back when we wanted it. We’d have to wait until someone else deposited some money and then we could take ours out. So, clearly, the bank doesn’t lend out all the deposits, just a very large portion of them. They’ll keep a few percent (at times and places an amount insisted upon by law, now not so much) in actual cash around for those who want their deposits back but they essentially rely upon the idea that we’re not all going to turn up and demand our money back in one go. Thus the bank is holding only a fraction of deposits in reserves and is lending out the rest: fractional reserve banking which is what we call the system.

So, that’s our set up of the system. There are other ways to do it (100% reserve banking for example but that would severely crimp economic growth as everyone since Adam Smith has pointed out) but this is the way that we do do it.

What could go wrong? Well, what happens if we all do turn up demanding our cash? Or even what happens if 5% of us do and that reserve is only 4%? The bank cannot pay us all back because it just doesn’t have the money. It’s in the mortgage of Mr. Jones down the street or that business loan that Ms. Smith has just used to install an accounting system. And we can’t sell those two things to get the money to appease the angry crowd milling around in front of the bank: we get a bank run. And all it requires is just the rumour that the bank doesn’t have enough cash for people to rush to be the first (and only!) people to get their cash back for it to be true that the bank doesn’t have enough money.

All of the above is well enough known and I’ve given the kindergarten version of it just to point out quite what a simple problem it is. The solution is also well known: the government provides deposit insurance. The bank might go bust, they might have lent everything to jackalope farmers but you, Mr. Depositor, will still get your money back (sometimes with limits, or a percentage, but that’s the general idea). People therefore don’t think the bank will run out of cash because the government stands behind them. Thus we don’t get bank runs.

Excellent, but what happened in 2007/08? As I’ve been saying for a number of years now (and as Gary Gorton confirms, but he’s a Professor and I’m not so listen to him not me) we in fact had two sets of depositors. We have the wholesale depositors and we have the individual and retail ones. That second group is you and me and we were insured. The first is what we might collectively call “Wall Street” or “ The City”. All of the other banks, the hedge funds, money market funds and so on. They were lending money to each other with gay abandon. But, crucially, they didn’t have deposit insurance. Plus, they were lending the money short (often only overnight) and the banks taking in those deposits were transforming them into longer term loans to their customers.

We can see that this is a system likely to be exposed to bank runs. For all the same reasons that Jimmy Stewart had to deal with in “It’s A Wonderful Life“. Just much bigger, much faster and far more worrying when it happened. As, indeed, it did happen. The classic example of recent times was Northern Rock. Really it was a mortgage bank: their main lending business was mortgages. Sure, they were aggressive in their lending (up to 125% of property value for example) but the underlying business was really very simple. Issue mortgages, using deposits from those wholesale markets. This is risky, because they were borrowing on 1 and 7 day terms and lending the money out on 30 year terms. Then, every few months, they would bundle up those mortgages they had issued into a bond issue and sell that. At which point they were maturity matched: they had borrowed for 15 or 20 years and that’s around the average life of a mortgage (as people move, pay up early and so on). So they were only exposed to that risk of a run on the amount of mortgages that they had issued but which were not yet in a bond.

And that’s exactly what happened. It was retail depositors who got worried first but once they had then those wholesale depositors got very worried indeed. Financing was not rolled over, Northern Rock could not borrow overnight to fund the mortgages it had issued and….well, there we go, first bank in the UK to go down from a bank run for over a century.

And that, effectively, is what happened to everyone. Lehman Brothers didn’t go down because it was bust (it might well have been but that wasn’t the reason) but because it couldn’t finance itself. Bear Sterns sold itself very quickly indeed for the same reason. Essentially what happened was wholesale runs on banking institutions. Runs which, arguably, would not have happened if there was some form of deposit insurance for wholesale depositors.