Shadow Banking and the Crisis of 2007-08

Daniel Sanches

Economic Advisor and Economist

Q2 2014

Business Review — In recent decades, institutions that function much like traditional banks have grown outside regulatory oversight. Yet, as Daniel Sanches explains, these so-called shadow banks are as vulnerable to runs as regular banks. Because banking crises can inflict lasting economic harm, economists are interested in tracing how panic ensued in the shadow system in 2007 and 2008.

Some economists have noted that recessions accompanied by banking crises tend to be deeper and more difficult to recover from than other recessions — even those associated with other types of financial crises. For instance, the bursting of the dot.com bubble in 2001 was a very important financial event that was not accompanied by a protracted recession. The potential of banking crises to do lasting economic harm led policymakers to adopt safeguards in the 1930s that have essentially eliminated traditional banking panics in the U.S. although the Great Recession of 2007-09 was associated with a protracted financial market disruption — and the failures of some large banks like Washington Mutual and IndyMac — we did not observe widespread withdrawals from commercial banks, as in a traditional banking crisis. However, economists Gary Gorton and Andrew Metrick show that it can be viewed as a banking crisis that originated in the shadow banking system. In the last 30 years, institutions very similar in function to traditional banks have grown outside regulatory oversight. One lesson of the financial crisis is that these institutions are as vulnerable to panics as traditional banks because they are subject to similar risks.

This article appeared in the Second Quarter 2014 edition of Business Review. Download and read the full issue.

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