How to stop the next run on shadow banking

The Richmond Federal Reserve Bank has published a review of the financial crisis of 2007 and 2008 that relies heavily on Yale economist Gary Gorton’s view that the heart of the crisis was a run on the repurchase market.

“The Run on shadow banking and a framework for reform” by Renee Courtois Haltom reviews two possible scenarios for reform, one from Gorton and one from Harvard Law School professor Morgan Ricks:

About Gorton’s ideas:

He supports a proposal that has been floated in
the wake of previous financial disturbances, that of “narrow banking.” Only a heavily regulated and restricted set of banks would be allowed to purchase securitized assets. They in essence would  manufacture safe collateral for the shadow
system to use, again, as currency in the market for funds. Effectively, the government would determine which securities are eligible to be used as collateral, verify their safety, and provide liquidity via the Fed’s discount window in the event of panic. This safe supply of collateral would have the potential to prevent future runs in shadow banking, though
it would also necessarily limit the supply (raise the cost) of maturity transformation services of banking and shadow banking.

About Ricks’ ideas:

Morgan Ricks offers an alternative solution. As suggested by the Diamond-Dybvig model, Ricks proposes to extend deposit insurance to the creditors of any entity that engages in maturity  transformation, or the type of “borrowing short
to lend long” that got many institutions into a funding bind during the crisis. If one thinks of repo and other loans as deposits in the shadow banking system, his proposal means the government would have to decide which deposits are funding “safe enough” investments. Then it would prohibit maturity transformation outside that circle — effectively, it would prohibit banking from taking place in the shadows. Insurance would come with regulation, activity restrictions, and, he argues, fees that would pay for it all, minimizing the exposure of taxpayers.

Haltom said Gorton sees limitations to regulation.

“Any time your system is dependent on the regulators
outsmarting the bankers, the bankers will win,” Gorton adds. The problem with most of the recent efforts at financial reform is they “just want to impose more and more regulations on these firms and that’s just going to move the banking system somewhere else.” An important lesson from
the crisis is that risky behavior will almost always move to the shadows.