Fed scholars: A run on the repurchase market caused the financial crisis and will probably happen again

The financial crisis of 2007-2008 was primarily a run on the repurchase market, when lenders refused to role over their repo loans to large investment banks.

This was like bank runs decades ago, when depositors rushed to take their money out of commercial banks, according to two visiting scholars at the Federal Reserve Bank of Minneapolis.

Severe recessions followed both runs, in 2008 and 1930, because frightened people ran on their banks and hoarded their cash and their safe investments like U.S. Treasuries. That caused banks to fail, normal financial transactions to grind to a halt and employment and production to contract. 

The recessions were not caused by the housing crash and the stock market crash that preceded the two recessions, respectively. They were caused by people’s opinion – whether or not correct – that they had to get their money out of a bank fast because it might fail, and that opinion frightened people at other banks, and the run spread, say the authors.

The potential for repo runs has not been fixed, the scholars write. It’s not addressed by the Dodd-Frank Act, and future crises probably cannot be prevented, but they can be made less severe. Bank runs, on the other hand, have been largely controlled since 1933 by FDIC insurance for deposits.

From the Minneapolis paper:

What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market. Massive lending by the Fed resolved the financial crisis, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.

Just before the September 2008 panic, conditions were ripe for a run, the authors argue.

 In August of 2008, the entire banking system held about $50 billion in actual cash reserves while clearing trades of $2,996 trillion per day. Yet every one of these trades involved an uncontingent promise to pay someone hard cash whenever he asked for it. If ever a system was “runnable,” this was it. 

The Minneapolis article is “Liquidity Crises – Understanding sources and limiting consequences: A theoretical framework,” by Robert E. Lucas, Jr. and Nancy L. Stokey, May 2011.

The authors call the 2008 and 1930 recessions “liquidity crises” because financial institutions were drained of so much money that they couldn’t conduct business or meet their financial obligations.

Some other economists called the 2008 panic an “insolvency crisis,” believing the banks weren’t just short of cash, they were broke – which they certainly would have been had the Federal Reserve not intervened.

University of Oregon economist Mark Thoma discussed the Minneapolis paper in his Economist’s View blog May 17:

I have talked quite a bit about how the financial crisis can be viewed as a traditional bank run in the non-traditional financial sector, the repo market in particular, and how, despite Dodd-Frank, we are still vulnerable to the non-traditional bank run problem. I’ve also talked about deposit insurance for firms engaged in maturity transformation as one potential way to reduce the likelihood of bank runs in the non-traditional system, and how fees and regulation can be used to offset the moral hazard problems that come with deposit insurance.

So it’s nice to see agreement with these ideas. In a new (surprisingly non-mathematical) paper, Robert Lucas and Nancy Stokey talk about how to build a theoretical model of liquidity crises, and use these ideas to examine how deposit insurance, regulation, and other policies can reduce, but not fully eliminate, the likelihood of a liquidity crises in the future.

The Dodd-Frank Act doesn’t reform repo, in part because experts don’t agree on how to fix it, the Minneapolis writers say.

It is hard to imagine better-motivated legislation than the Dodd-Frank Act, to date the one measure directed at preventing future financial crises. Yet it is hard to find an economist who argues that Dodd-Frank represents any appreciable progress toward this goal, nor is there anything like a consensus among its critics on what legislation should supplement or replace it. Economists cannot yet offer a complete, agreed-upon theoretical framework for thinking about liquidity crises, about the forces that precipitate them or exacerbate them or both.

What distinguishes the crises of 2008 and 1930 from other momentous financial events, such as the stock market crash in 1929, the dot.com/telecom collapse in 2000, and the housing collapse in 2007?  The paper explains:

The stock market crash of 1929 and the dot-com crash of 2000 are two examples (of collapses that weren’t liquidity crises). These large, sudden changes in stock prices reflected changes in beliefs about future returns, but they did not have large, immediate effects on the inventories of cash or other liquid assets that individuals and firms wanted to hold, relative to the volume of their spending.

Another example is the unexpected fall in house prices in 2007–08, which led to a reduction in construction activity. Housing construction is a large enough industry that this reduction would have shown up in a decline in overall gross domestic product (GDP), but it would have been comparable in size to other recessions of the postwar era. (Of course, mortgage-backed securities, marketed as liquid assets, did play a central role in the financial crisis, and that role will be discussed below.) The events that followed the failure of Lehman Brothers in September of 2008 were not a modest recession. The spending declines in the fourth quarter of 2008 and the first quarter of 2009 sent U.S.GDP from 3 percent or 4 percent below trend to 8 percent or 9 percent below, where it has remained ever since.  Housing was only a tangential factor in this decline.

During the 2008 crisis, deposit insurance was a source of strength, the writers note. Between January 2008 and January 2009, FDIC-insured bank deposits grew, as did investments in money market funds, which were temporarily guaranteed during the crisis.

Repurchase agreements, on the other hand, fell 30 percent.

Deposit insurance, however, makes bank lenders and depositors think they can stop worrying about safety and simply seek the bank that pays them the most interest, regardless of how risky its business practices might be. 

The authors draw five lessons from the panic of 2008. Here are brief summaries:

-Bank regulation can reduce the likelihood of liquidity crises, but cannot eliminate them entirely.

-During a liquidity crisis, the Fed should act as a lender of last resort.

-The Fed should announce its policy for liquidity crises, explaining how and under what circumstances it will come into play.

-Deposit insurance is part of the answer, but has a limited role.

-The Fed’s lending in a crisis should be targeted toward preserving market liquidity, not particular institutions.

Avoiding liquidity crises altogether is probably more than we can hope for. What we can do is put in place mechanisms to make such crises infrequent and to make their effects manageable.