ABSTRACT The shadow banking system played a major role in the
recent financial crisis but remains largely unregulated. We propose
principles for its regulation and describe a specific proposal to
implement those principles. We document how the rise of shadow banking
was helped by regulatory and legal changes that gave advantages to three
main institutions: money-market mutual funds (MMMFs) to capture retail
deposits from traditional banks, securitization to move assets of
traditional banks off their balance sheets, and repurchase agreements
(repos) that facilitated the use of securitized bonds as money. The
evolution of a bankruptcy safe harbor for repos was crucial to the
growth and efficiency of shadow banking; regulators can use access to
this safe harbor as the lever to enforce new rules. History has
demonstrated two successful methods for regulating privately created
money: strict guidelines on collateral, and government-guaranteed
insurance. We propose the use of insurance for MMMFs, combined with
strict guidelines on collateral for both securitization and repos, with
regulatory control established by chartering new forms of narrow banks
for MMMFs and securitization, and using the bankruptcy safe harbor to
incentivize compliance on repos.
After the Great Depression, by some combination of luck and genius,
the United States created a bank regulatory system that oversaw a period
of about 75 years free of financial panics, considerably longer than any
such period since the founding of the republic. When this quiet period
finally ended in 2007, the ensuing panic did not begin in the
traditional system of banks and depositors, but instead was centered in
a new "shadow" banking system. This system performs the same
functions as traditional banking, but the names of the players are
different, and the regulatory structure is light or nonexistent. In its
broadest definition, shadow banking includes such familiar institutions
as investment banks, money-market mutual funds (MMMFs), and mortgage
brokers; some rather old contractual forms, such as sale-and-repurchase
agreements (repos); and more esoteric instruments such as asset-backed
securities (ABSs), collateralized debt obligations (CDOs), and
asset-backed commercial paper (ABCP). (1)
Following the panic of 2007-09, Congress passed major regulatory
reform of the financial sector in the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010. Dodd-Frank includes many provisions
relevant to shadow banking; for example, hedge funds must now register
with the Securities and Exchange Commission (SEC), much over-the-counter
derivatives trading will be moved to exchanges and clearinghouses, and
all systemically important institutions will be regulated by the Federal
Reserve. Retail lenders will now be subject to consistent, federal-level
regulation through the new Consumer Financial Protection Bureau housed
within the Federal Reserve.
Although Dodd-Frank takes some useful steps in the regulation of
shadow banking, there are still large gaps where it is almost silent.
Three important gaps involve the regulation of MMMFs, securitization,
and repos. Fortunately, the law also created a council of regulators,
the Financial Stability Oversight Council, with significant power to
identify and manage systemic risks, including the power to recommend
significant changes in regulation, if deemed necessary for financial
stability. (2) We will argue that the above three areas played the
central role in the recent crisis and are in need of further regulation.
MMMFs, securitization, and repos are key elements of what has been
called off-balance-sheet financing, which differs from the
on-balance-sheet financing of traditional banks in several important
ways. Figure 1 is the classic textbook depiction of the financial
intermediation of loans on bank balance sheets in the traditional
banking system. In step A depositors transfer money to the bank in
return for credit on a checking or savings account, from which they can
withdraw at any time. In step B the bank lends these funds to a borrower
and holds this loan on its balance sheet to maturity.
[FIGURE 1 OMITTED]
Historically, the traditional system was subject to bank runs, but
these were ended in the United States in 1934 through the introduction
of federal deposit insurance. With deposits thus insured, depositors
have little incentive to withdraw their funds when the solvency of the
bank comes into question. Deposit insurance works well for retail
investors but leaves a challenge for institutions with large cash
holdings. With deposit insurance capped at $100,000 per account,
institutions such as pension funds, mutual funds, states and
municipalities, and cash-rich nonfinancial companies lack easy access to
safe, interest-earning, short-term investments. The shadow banking
system of off-balance-sheet lending (figure 2) provides a solution to
Step 2 in figure 2 is the analogue to step A in figure 1, but with
one important difference. To achieve protection similar to that provided
by deposit insurance, an MMMF or other institutional investor receives
collateral from the bank. In practice, this transaction takes the form
of a repo: the institutional investor deposits and receives some asset
from the bank as collateral; the bank agrees to repurchase the same
asset at some future time (perhaps the next day) for . The percentage (Y
- X)/X is called the repo rate and (when annualized) is analogous to the
interest rate on a bank deposit.
[FIGURE 2 OMITTED]
Typically, the total amount deposited will be some amount less than
the value of the asset used as collateral; the difference is called a
"haircut." For example, if an asset has a market value of $100
and a bank sells it for $80 with an agreement to repurchase it for $88,
the repo rate is 10 percent (= [88 - 80]/80) and the haircut is 20
percent ([100 - 80]/100). If the bank defaults on its promise to
repurchase the asset, the investor keeps the collateral. (3)
The step that moves this financing off the balance sheet of the
bank is step 4, where loans are pooled and securitized. We will discuss
this step in detail in section I. For now, the key idea is that the
outputs of this securitization are either purchased directly by
institutional investors in step 5 or used as collateral for other loans
in step 2. In effect, the bonds created by securitization are often the
main source of collateral that provides insurance for large depositors.
[FIGURE 3 OMITTED]
Each of the components in this off-balance-sheet financing cycle
has grown rapidly since 1980. The most dramatic growth has been in
securitization: Federal Reserve Flow of Funds data show that the ratio
of off-balance-sheet to on-balance-sheet loan funding grew from zero in
1980 to over 60 percent in 2007. To illustrate the growth in MMMFs,
figure 3 shows total bank assets, bank demand deposits, mutual fund
assets, and MMMF assets as percentages of total financial assets: the
bank share of total assets fell by about 20 percentage points from 1980
As we discuss later, there are no comprehensive data measuring the
repo market. However, an indication of its growth is the growth in the
balance sheets of the institutions that play the role of banks in repo
transactions as depicted in figure 2. Before the crisis, these were
essentially the investment banks, or broker-dealers. In order for these
institutions to act as banks and offer repos, they needed to hold bonds
that could be used as collateral. The yield on the collateral accrues to
the bank, which pays the repo rate. So, for example, if the bond is an
asset-backed security with a coupon rate of 6 percent, and the repo rate
is 3 percent, the bank earns the difference. This required that their
balance sheets grow significantly as the repo market grew. Figure 4
shows that broker-dealer assets indeed grew rapidly after about 1990,
while commercial bank assets grew at a rate much closer to that of GDP.
[FIGURE 4 OMITTED]
Why did shadow banking grow so much? We address this question in
section I. One force came from the supply side, where a series of
innovations and regulatory changes eroded the competitive advantage of
banks and bank deposits. A second force came from the demand side, where
demand for collateral for financial transactions gave impetus to the
development of securitization and the use of repos as a money-like
instrument. Both of these forces were aided by court decisions and
regulatory rules that allowed securitization and repos special treatment
under the bankruptcy code. A central idea of this paper is that the
bankruptcy safe harbor for repos has been crucial to the growth of
shadow banking, and that regulators can use access to this safe harbor
as the lever to enforce minimum repo haircuts and control leverage.
If the growth of shadow banking was central to the crisis and was
facilitated by regulatory changes, then why not simply reverse all these
changes? Would such reversals bring us back to a safer system dominated
by traditional banks? We do not believe that such a radical course is
possible even if it were desirable, which it is not, in our view. The
regulatory changes were, in many cases, an endogenous response to the
demand for efficient, bankruptcy-free collateral in large financial
transactions: if repos had not been granted this status, the private
sector would have sought a substitute, which likely would have been even
less efficient. In any case, we will not try in this paper to justify
the existence of the shadow banking system. Instead we take the broad
outlines of the system as given and ask how the current regulatory
structure could be adapted to make the system safer without driving its
activity into a new unregulated darkness.
In section II we discuss how the shadow banking system broke down
in the crisis. The features of this breakdown are similar to those from
previous banking panics: safe, liquid assets suddenly appeared to be
unsafe, leading to runs. MMMFs, which appeared to be as safe as insured
deposits to many investors, suddenly appeared vulnerable, leading to
runs on those funds. Securitization, which investors had trusted for
decades as creating a form of "information-insensitive"
securities free of adverse selection problems, suddenly lost the
confidence of investors: hundreds of billions of dollars of formerly
information-insensitive triple-A-rated securities became
information-sensitive. (4) Since the cost of evaluating all this newly
suspect paper was high, investors simply exited all securitizations. In
this new environment the high-quality collateral necessary for repos no
longer existed. In Gorton and Metrick (forthcoming), we claim that the
resulting run on repos was a key propagation mechanism in the crisis.
Section III applies lessons from the successful regulation of
traditional banking to inter principles for the regulation of shadow
banking. History has demonstrated two methods for reducing the
probability of runs in a system. The first, standardized
collateralization, was introduced after the Panic of 1837, when some
states passed free banking laws under which state bonds were required to
back paper bank notes. Free banking laws were the basis for the National
Bank Acts, which created national bank notes backed by U.S. Treasury
securities as collateral; these notes were the first currency in the
United States to trade at par against specie. The second method,
government insurance, was tried at the state level without great success
before the Civil War and again in the first decades of the 20th century.
Success finally came when, during the Great Depression, the Federal
Deposit Insurance Corporation (FDIC) was created to insure demand
deposits. This innovation stopped the cycle of runs on demand deposits
and allowed them to be used safely as money.
Today, repos have emerged as a new monetary form, and history
offers the same two methods to consider for stabilizing their use. As
discussed in detail in section IV, which describes our specific
proposals, we believe that insurance would be workable for MMMFs, but
that collateralization would be preferable for repos and securitization.
For MMMFs the problems are straightforward and have already been well
addressed by other authors. We adopt the proposal of the Group of Thirty
(2009): MMMFs would have the choice of being treated either as narrow
savings banks (NSBs) with stable net asset values, or as conservative
investment funds with floating net asset values and no guaranteed
return. Under this system, the former would fall clearly within the
official financial safety net, but the latter would not. (5)
The narrow banks proposed by the Group of Thirty for MMMFs provide
a model for regulating securitization based on the chartering of
"narrow funding banks" (NFBs) as vehicles to control and
monitor securitization, combined with regulatory oversight of acceptable
collateral and minimum haircuts for repos. Under this regime the rules
for acceptable collateral would allow that collateral to play a role
analogous to that of the state bonds backing bank notes in the free
banking period, or the U.S. Treasury securities backing greenbacks
during the national banking era; minimum repo haircuts would play a role
analogous to capital ratios for depository institutions. The danger of
exit from this system and the creation of yet another shadow banking
system would be mitigated by allowing only licensed NFBs and repos the
special protections provided under the bankruptcy code.
Section V concludes with a discussion of related topics in
regulation and monetary policy. The appendix supplements the text with a
glossary of shadow banking terminology used in the paper.
I. The Rise of Shadow Banking
Shadow banking is the outcome of fundamental changes in the
financial system in the last 30 to 40 years, as a result of private
innovation and regulatory changes that together led to the decline of
the traditional banking model. Faced by competition from nonbanks and
their products, such as junk bonds and commercial paper, on the asset
side of their balance sheets, and from MMMFs on the liability side,
commercial banks became less profitable and sought new profit
opportunities. (6) Slowly, traditional banks exited the regulated
sector. In this section we review in more detail the three important
changes in banking discussed briefly above: MMMFs, securitization, and
I.A. Money-Market Mutual Funds
Since the 1970s there has been a major shift in the preferred
medium for deposit-like transactions away from demand deposits toward
MMMFs. (7) MMMFs were a response to interest rate ceilings on demand
deposits (Regulation Q). In the late 1970s the assets of MMMFs totaled
around $4 billion. In 1977 interest rates rose sharply and MMMFs grew in
response, by more than $2 billion per month during the first 5 months of
1979 (Cook and Duffield 1979). The Garn-St. Germain Act of 1982
authorized banks to issue short-term deposit accounts with some
transaction features but no interest rate ceiling. These were known as
"money-market deposit accounts." Michael Keeley and Gary
Zimmerman (1985) document that these accounts attracted $300 billion in
the 3 months after their introduction in December 1982, and they argue
that the result was a substitution of wholesale for retail deposits, and
of direct price competition for nonprice competition, both responses
resulting in increased bank deposit costs. MMMFs really took off in the
mid-1980s, their assets growing from $76.4 billion in 1980 to $1.8
trillion by 2000, an increase of over 2,000 percent. Assets of MMMFs
reached a peak of $3.8 trillion in 2008, making them one of the most
significant financial product innovations of the last 50 years.
An important feature of MMMFs that distinguishes them from other
mutual funds is that they seek to maintain a net asset value of $1 per
share. It is this feature that enables MMMFs to compete with insured
demand deposits. MMMFs are closely regulated; they are required, for
example, to invest only in high-quality securities that would seem to
have little credit risk. The SEC has recently proposed a series of
changes to MMMF regulation; these regulations, part of the Investment
Company Act of 1940 (as amended), have come under review by a working
group of regulators, but none of the recent proposals would change the
fact that MMMFs are not explicitly insured. The maintenance of the $1
share price was almost universally successful in the decades leading up
to the crisis. This may have instilled a false sense of security in
investors who took the implicit promise as equivalent to the explicit
insurance offered by deposit accounts. The difference, of course, is
that banks pay for deposit insurance (and pass that cost along to
depositors), whereas the promise to pay $1 per share costs the MMMFs
nothing. In the crisis, the government made good on the implicit promise
by explicitly guaranteeing MMMFs, and in the wake of that move it may
not be credible for the government to commit to any other strategy. As
long as MMMFs have implicit, cost-free government backing, they will
have a cost advantage over insured deposits. We return to this point in
section IV, where we adopt the proposals of the Group of Thirty (2009)
for MMMFs to either pay for explicit insurance or drop the fiction of
Securitization is the process by which traditionally illiquid loans
are packaged and sold into the capital markets. This is accomplished by
selling large portfolios of loans to special purpose vehicles (SPVs),
which are legal entities that in turn issue rated securities linked to
the loan portfolios. Figure 5 illustrates how securitization works. An
originating firm lends money to a number of borrowers. A number of these
loans are then pooled into a portfolio, which is sold to an SPV, a
master trust in the figure. The SPV finances these purchases by selling
securities in the capital markets. These securities are classified into
tranches, which are ranked by seniority and rated accordingly. The whole
process thus takes loans that traditionally would have been held on the
balance sheet of the originating firm and creates from them marketable
securities that can be sold and traded via the off balance-sheet SPV.
Securitization is a large and important market. Figure 6 shows the
annual issuance since 1990 of all securitized products, including
nonagency mortgage-backed securities, the major nonmortgage categories
(credit card receivables, auto loans, and student loans), and other
asset classes; for
comparison, the figure also shows the annual issuance of corporate
bonds (including convertible debt). Starting at about the same level,
the two series rise roughly in parallel until around 2000, when
securitization begins to grow explosively. Securitization peaks in 2006
and then falls precipitously in the crisis.
[FIGURE 5 OMITTED]
[FIGURE 6 OMITTED]
To understand the potential economic efficiencies of
securitization, it is important to understand how the SPV structure
works. An SPV has no purpose other than the transaction or transactions
for which it was created; it can make no substantive decisions. The
rules governing SPVs are set down in advance and carefully circumscribe
their activities. Indeed, no one works at an SPV, and it has no physical
Two other essential features of an SPV concern bankruptcy. First,
SPVs are "bankruptcy remote"; that is, the insolvency of the
sponsor (the bank or firm originating the loans) has no impact on the
SPV. In particular, creditors of a bankrupt sponsor cannot claw back
assets from the SPV. Second, the SPV itself is designed so that it can
never, as a practical matter, become legally bankrupt. The most
straightforward way to achieve this would be for the SPV to waive its
right to file a voluntary bankruptcy petition, but this is legally
unenforceable. So the way to minimize the risk of either voluntary or
involuntary bankruptcy is to design the SPV in a way that makes the risk
of bankruptcy very small. (9)
Why would a bank choose to move some assets off its balance sheet
through securitization? There are several costs and benefits of this
decision, all of which have been changing rapidly over the last several
BANKRUPTCY. The most important design feature of securitization is
that the ABSs issued by an SPV do not trigger an event of default in the
case where the underlying portfolio does not generate enough cash to
make the contractual coupon payments on the outstanding bonds. (10)
Instead there is an early amortization event: the cash that is available
is used to make principal payments early, rather than coupon payments.
Avoiding Chapter 11 bankruptcy is valuable. Thomas Plank (2007, p.
654) compares securitization with what happens to a secured creditor in
bankruptcy and concludes that "securitization reduces the
bankruptcy tax on secured lenders to originators and owners of mortgage
loans and other receivables, and therefore has reduced the bankruptcy
premiums charged to the obligors of mortgage loans and other
receivables." Gorton and Nicholas Souleles (2006) show empirically
that this is an important source of value to securitization.
TAXES. Debt issued off the balance sheet does not have the
advantageous tax benefits of on-balance-sheet debt. For profitable firms
this can make a large difference. Consider a bank that is deciding how
to finance a portfolio of mortgage loans that has the same risk
properties as the rest of the bank's assets. Profitable firms with
little chance of bankruptcy have a high likelihood of being able to
treat the interest on that debt as a deductible expense, and so for
these firms it is optimal to finance on the balance sheet. For firms
that are less profitable and closer to bankruptcy, which therefore have
a lower likelihood of using this tax shield, it will be relatively more
advantageous to finance off the balance sheet. Gorton and Souleles
(2006) find this to be true empirically, in a study of credit card
securitizations. Using credit ratings as a measure of profitability and
bankruptcy risk, Moody's (1997a, 1997b) also reaches this
MORAL HAZARD. Because the rules governing SPVs permit them very
little discretion, once a portfolio of loans has been transferred to an
SPV, there is no danger of other activities of the SPV imposing costs on
the holders of the securitized bonds. In contrast, the expected
bankruptcy costs to the holder of a bank's bonds are affected by
the other actions of bank management.
Given the fiduciary responsibilities of corporate directors toward
equity holders, and given the familiar principal-agent problems among
shareholders, directors, and managers, moral hazard will always be a
potential concern for bank bondholders. But this concern can be
mitigated by the existence of bank "charter value." As
discussed by Alan Marcus (1984), a positive charter value gives a bank
an incentive to avoid risk taking that might lead to bankruptcy and the
loss of the charter. Bank regulations and positive charter values are
complementary in that banks tend to abide by regulations--that is, they
internalize risk management--when charter values are high. There is
persuasive evidence that, historically, such charter value at banks did
improve risk management, but that this value and the protection it
provided have decreased over time. The competition from junk bonds and
MMMFs, together with deregulation (for example, of interest rate
ceilings), caused bank charter values to decline, which in turn led
banks to increase their risk and reduce their capital. (11)
Given the decline in charter values and the resulting increase in
bank risk taking, bank bondholders would face higher moral hazard costs
for on-balance-sheet financing and demand higher returns as
compensation. This provides a cost advantage to securitization that has
been growing over time.
REGULATORY COSTS. One regulatory response to increased risk taking
by banks has been the introduction of specific capital requirements. In
1981 regulators announced explicit capital requirements for the first
time in U.S. banking history: all banks and bank holding companies were
required to hold primary capital of at least 5.5 percent of assets by
June 1985. Virtually all banks did meet these capital requirements by
1986, but it is interesting how this was accomplished: banks that were
capital deficient when the new requirements were announced tended to
grow more slowly than capital-rich banks (Keeley 1988). (12)
If bank regulators impose capital requirements that are binding
(that is, that require banks to hold more capital than they would
voluntarily in equilibrium), then, when charter value is low, bank
capital will exit the regulated bank industry. One way to do this is
through off-balance-sheet securitization, which has no requirements for
ADVERSE SELECTION. It is sometimes alleged that an investor in
securitized bonds faces an adverse selection problem: loan originators
who have better information about the loans than the investor has might
try to put the worst loans into the portfolio being sold to the SPV.
Aware of this problem, investors and sponsoring firms have designed
several structural mitigants. First, loan originators are allowed
limited discretion in selecting loans for the portfolio to be
securitized. The loans are subject to detailed eligibility criteria and
specific representations and warranties. Once eligible loans have been
specified, either they are selected for the portfolio at random, or all
the qualifying loans are put into the portfolio. Second, originators of
securitizations retain a residual interest (essentially the equity
position) in them. In principle, these features align the interests of
securitization investors and loan originators (Gorton 2010), and indeed,
except in the case of subprime mortgages, securitization has worked
well. When an entire asset class turns out to be suspect, as happened
with subprime mortgage securitization, there is clearly a problem, but
it is not adverse selection. With respect to subprime securitizations,
the evidence on adverse selection remains ambiguous. (13)
TRANSPARENCY AND CUSTOMIZATION. Evaluation of the creditworthiness
of any bank requires analyses of its balance sheet, operations,
management, competitors, and so on. Information on each of these
elements is at best only partly disclosed to bank investors, and even in
the absence of moral hazard problems, creditworthiness can vary over
time from changes in ordinary business operations. (14) In comparison,
an SPV's portfolio is completely known, and any changes over time
are noted in the trustee reports. Although the underlying SPV portfolio
may contain thousands of individual assets and is by no means simple to
evaluate, it is considerably more transparent than a corresponding bank
balance sheet, which may have many such collections of assets and zero
disclosure of individual loans.
With the ability to disclose specific assets underlying securitized
bonds, off-balance-sheet financing can allow customization of such bonds
for any niche of investors. Investors desiring exposure to (or hedges
against) mortgages, auto loans, or credit card receivables can purchase
exactly what they want through securitized bonds without having to take
on exposure to any other type of asset. Furthermore, although banks can
and do offer their own debt at different levels of seniority, the
transparency of SPV portfolios allows for easier evaluation of the
different tranches. One specific type of customization is used to create
safe senior tranches that can trade as information-insensitive,
triple-A-rated securities. The production of these senior tranches was
in part an endogenous response to a rising demand for safe collateral in
repos and other financial transactions. We discuss this special case in
the next subsection.
[FIGURE 7 OMITTED]
One key driver of the increased use of repos is the rapid growth of
money under management by institutional investors, pension funds, mutual
funds, states and municipalities, and nonfinancial firms. These entities
hold cash for various reasons but would like to have a safe investment
that earns interest, while retaining flexibility to use the cash when
needed--in short, a demand deposit-like product. In the last 30 years
these entities have grown in size and become an important feature of the
financial landscape. For example, according to the Bank for
International Settlements (BIS 2007, p. 1, note 1), "In 2003, total
world assets of commercial banks amounted to USD 49 trillion, compared
to USD 47 trillion of assets under management by institutional
investors." Figure 7 shows this increase as a ratio of GDP in five
large economies: the median ratio more than tripled from 1980 to 2007.
For large depositors like these, repos can act as a substitute for
insured demand deposits because repo agreements are explicitly excluded
from Chapter 11: that is, they are not subject to the automatic stay.
Instead, repos, like derivatives, have a special status under the U.S.
Bankruptcy Code. The repo contract allows either party to unilaterally
enforce the termination provisions of the agreement as a result of a
bankruptcy filing by the other party. A depositor, for example, can
unilaterally terminate its repo with a bank when the bank becomes
insolvent and sell the collateral. Without this protection, a party to a
repo contract would be just another creditor waiting for the bankruptcy
proceedings to conclude in order to be repaid. (15)
Repo collateral can be rehypothecated; that is, the collateral
received in a repo deposit can be freely reused in another transaction
with an unrelated third party. For example, bonds received as collateral
can be posted to a third party as collateral in a derivatives
transaction; that party can then borrow against the same collateral, and
so on. As the BIS (1999, pp. 7-8) has pointed out, this results in
"high levels of 'velocity' in repo markets. This occurs
when a single piece of collateral is used to effect settlement in a
number of contracts on the same day. It allows the daily repo trading
volume of a particular note issue to exceed the outstanding amount of
the issue, as participants are able to borrow and lend a single piece of
collateral repeatedly over the course of a day." Manmohan Singh and
James Aitken (2010) argue that measures of repos are significantly
larger when rehypothecation is taken into account. (16)
The legal infrastructure facilitating the use of repos as money has
evolved as their volume has grown. Since 1978, the year a new bankruptcy
code was adopted, both the U.S. Bankruptcy Code and the Federal Deposit
Insurance Act have provided exemptions for certain kinds of financial
contracts. It was in 1984 that the bankruptcy code was amended to allow
parties to a repo to liquidate collateral without the counterparty going
into bankruptcy. (17) But this applied only to repos based on Treasury
securities, agency securities, bank certificates of deposit, and
bankers' acceptances. (18) In 2005 the Bankruptcy Reform Act
expanded the definition of a repo to make transactions based on any
stock, bond, or other security eligible for bankruptcy safe harbor
The unfortunate reality is that no official data on repos exist
other than what the Federal Reserve collects with regard to the amounts
transacted by the 18 primary dealer banks. According to these data,
primary dealers reported financing $4.5 trillion in fixed-income
securities with repos as of March 4, 2008. However, these data are known
to cover only a fraction of the U.S. market. (20) BIS economists Peter
Hordahl and Michael King (2008, p. 37) report that repo markets doubled
in size from 2002 to 2007, "with gross amounts outstanding at
year-end 2007 of roughly $10 trillion in each of the US and euro repo
markets, and another $1 trillion in the UK repo market." They also
report that the U.S. repo market exceeded $10 trillion in mid-2008,
including double counting. (21) The European repo market, generally
viewed as smaller than the U.S. market, was 4.87 trillion [euro] in June
2009, having peaked at 6.78 trillion [euro] in June 2007, according to
the International Capital Market Association (ICMA) European Repo Market
Survey (2010). According to figures published in ICMA's June 2009
survey, the repo market globally grew at an average annual rate of 25
percent between 2001 and 2007. Although the available evidence strongly
suggests that the repo market is very large, it is impossible to say how
large it is in the United States.
We have described the repo market as essentially a deposit market,
but repos have a number of other significant uses as well. They are used
to hedge derivative positions and to hedge primary security issuance.
Repos are also important for maintaining "no arbitrage"
relationships between cash and synthetic instruments. A very important
use of repos is in taking "short" positions in securities
markets. By using a repo, a market participant can sell a security that
he or she does not own by borrowing it from another party in the repo
market. Without a repo market (or an analogous market transaction using
collateral), this would be impossible. Repos are also an important
mechanism for obtaining leverage, especially for hedge funds. There are
many such examples. It is for all these reasons that repos have been
described as the core of the financial system (Comotto 2010).
II. The Role of Shadow Banking in the Financial Crisis
The chronology of events in the financial crisis of 2007-09 is well
known, and a growing number of papers address various aspects of the
crisis. (22) In this section we briefly summarize the crisis as a run on
various forms of "safe" short-term debt.
A proximate cause of the crisis was a shock to home prices, which
had a large detrimental effect on subprime mortgages. In turn, ABSs
linked to subprime mortgages quickly lost value. The shock spread
quickly to other asset classes as entities based on short-term debt were
unable to roll over the debt or faced withdrawals. Essentially, there
was a run on short-term debt. The epicenters were the repo market, the
market for ABCP, and MMMFs. We briefly discuss each in turn.
Gorton and Metrick (2010, forthcoming) and Gorton (2010) have
argued that the core problem in the financial crisis was a run on repos.
The panic occurred when depositors in repo transactions with banks
feared that the banks might fail and they would have to sell the
collateral in the market to recover their money, possibly at a loss
given that so much collateral was being sold at once. In reaction,
investors increased repo haircuts. Tri Vi Dang, Gorton, and Bengt
Holmstrom (2010a, 2010b) argue that a haircut amounts to a tranching of
the collateral to recreate an information-insensitive security in the
face of the shock, so that it is again liquid.
An increase in a repo haircut is tantamount to a withdrawal from
the issuing bank. Think of a bond worth $100 that was completely
financed in the repo market with a zero haircut. A 20 percent haircut on
the same bond would require that the bank finance $20 some other way. In
effect, $20 has been withdrawn from the bank. If no one will provide
financing to the bank through new security issuance or a loan, the bank
will have to sell assets. In the crisis, withdrawals in the form of
increased repo haircuts caused deleveraging, spreading the subprime
crisis to other asset classes.
It was not only in the repo market that problems occurred. There
were also runs on other types of entities that were heavily dependent on
short-term debt and held portfolios of ABSs. ABCP conduits and
structured investment vehicles (SIVs) are operating companies that
purchased long-term ABSs and financed them with short-term debt, largely
commercial paper. Just before the crisis began, ABCP conduits had about
$1.4 trillion in total assets (Carey, Correa, and Kotter 2009). Most
ABCP programs were sponsored by banks. Daniel Covits, Nellie Liang, and
Gustavo Suarez (2009, p. 7) report that "more than half of ABCP
daily issuance has maturities of 1 to 4 days [referred to as
"overnight"], and the average maturity of outstanding paper is
about 30 days" (see also Carey, Correa, and Kotter 2009). Our
reform proposals below also address ABCP conduits and SIVs.
MMMFs were also hit hard during the crisis. MMMFs are not just a
retail product; they managed 24 percent of U.S. business short-term
assets in 2006 (Brennan and others 2009). At that time, just before the
crisis, these funds held liabilities of ABCP conduits, SIVs, and
troubled financial firms such as Lehman Brothers. Upon Lehman's
failure, concern that these funds would have trouble maintaining their
implicit promise of a $1 net asset value induced some investors to
withdraw their funds. Faced with a run, these entities were forced to
sell assets at fire-sale prices (Brennan and others 2009). There was a
flight to quality: investors moved assets out of MMMFs that invested
mainly in private sector debt and into MMMFs that primarily invested in
U.S. Treasury debt. From September to December 2008, the former suffered
a net cash outflow of $234 billion while the latter received a net
inflow of $489 billion (Brennan and others 2009). On September 29, 2008,
the government announced its Temporary Guarantee Program for Money
Market Funds; this temporarily guaranteed certain account balances in
MMMFs that qualified.
In summary, the financial crisis was centered in several types of
shortterm debt (repos, ABCP, MMMF shares) that were initially perceived
as safe and "money-like" but later found to be imperfectly
collateralized. In this way the crisis amounted to a banking panic,
structurally similar to centuries of previous panics involving
money-like instruments such as bank notes and demand deposits, but with
the "banks" taking a new form. To regulate this new form of
banking, we turn next to the lessons of history.
III. Lessons from History and Principles for Reform
Bank regulation has been at the forefront of public policy issues
in finance since the founding of the United States. The essential
feature of banking is the provision of "money," that is, a
medium that can be easily used to conduct transactions without losses to
insiders (that is, the better-informed party). Throughout U.S. history,
a central aim of government involvement has been to provide a regulatory
structure that ensures the existence of such a safe medium of exchange
and avoids systemic banking crises. Before the creation of federal
deposit insurance in 1934, the government's efforts to ensure the
safety of bank-produced media of exchange took two primary forms. The
first was safe and transparent collateral backing for bank money. The
idea was that instead of backing bank money with opaque long-term loans,
it should be backed by specified government securities. The second was
various kinds of insurance schemes tried by the states. It is also worth
commenting briefly on the role of private bank clearinghouses, which
developed into institutions that sought to safeguard the credibility of
bank money. In this section we briefly review these regulatory attempts.
Before the Civil War the predominant form of bank money was
privately issued bank notes. These were issued by banks at par, but when
used at some distance from the issuing bank, they were accepted only at
a discount (see, for example, Gorton 1996, 1999), This early period of
banking in the United States was plagued with difficulties, and various
solutions were proposed. For the sake of brevity, we start our
examination with the Panic of 1837. (23)
The Panic of 1837 disclosed the defects of the New York Safety Fund
System and ushered in that state's Free Banking Act of 1838. (24)
The Safety Fund had been established in New York in 1829 as an insurance
system. Each member bank was required to make periodic contributions, as
a percentage of its capital, to a fund for the payment of the debts of
any insolvent member after its own assets had been exhausted. Of course,
the problem was that the bank had to be insolvent in order for claims to
be made on the fund, but at least in principle the note holders would
not suffer losses. The Panic of 1837 was the first test of the Safety
Fund. Banks suspended convertibility of notes and deposits into specie
in May of that year. Later that year came the first calls on the Safety
Fund. In the end, the fund was not adequate to meet all the demands made
on it from the debt of insolvent banks, even with an extra tax on member
banks. The fund was basically abandoned: although it continued for
chartered banks until 1866, very few banks participated.
New York's Free Banking Act, imitated by many (but not all)
other states, introduced a fundamental idea into the design of banking:
the use of explicit and mostly transparent collateral to back the
issuance of private money. (25) Free banking laws had the following
standard features: entry was relatively easy, requiring no special state
legislation (previously a state banking charter had required a specific
act of the legislature); free banks were required to post eligible state
bonds with the state auditor as collateral for notes issued (some states
allowed federal bonds also); free banks were required to pay specie on
demand or would (after a grace period) forfeit their charter; free banks
were organized as limited liability firms. Our concern is with the bond
collateral. The eligible bonds were publicly known, and what bonds were
posted by each bank was also known. The state auditor kept the
bank's printing plates and printed the notes.
The bond backing system worked in principle, but in practice the
collateral--the state bonds--was not riskless. Arthur Rolnick and Warren
Weber (1984) show that free banks failed when the value of the bonds
they posted as collateral fell. The Panic of 1857, which largely
involved another bank liability that had grown enormously, namely,
demand deposits, revealed the deficiencies of a system that backed note
issuance with bank bonds.
The use of bond collateral for note issuance under the free banking
laws was the basis for the most successful financial legislation in U.S.
history, the National Bank Acts. According to Andrew Davis (1910, p. 7),
"The success of [free banking] suggested that a uniform national
currency might in the same way be provided through the emissions of
special associations [national banks], which should secure their notes
by the pledge of government securities." Partly as a way of
financing the Civil War, Congress passed the National Bank Acts in 1863
and 1864 to create a uniform federal currency. National bank notes were
liabilities of a new category of banks, called "national
banks." They could issue notes upon depositing U.S. Treasury
securities with the federal government equal in face value to 111
percent (later reduced to 100 percent) of the value of notes issued.
After the Panic of 1873, banks were further required to make deposits
into a Treasury-run redemption tend. As Milton Friedman and Anna
Schwartz (1963, p. 21) summarized, "Though national bank notes were
nominally liabilities of the banks that issued them, in effect they were
indirect liabilities of the federal government thanks to both the
required government bond security and the conditions for their
redemption." National bank notes circulated at par, and there were
none of the problems that had plagued the antebellum period. But
although these notes remained safe, panics did occur during the national
banking period, in 1873, 1884, 1893, 1907, and 1914. It was these
panics, centered on demand deposits rather than bank notes, that
eventually led to the creation of federal deposit insurance through the
Deposit insurance has a long history in the United States, dating
back to the New York Safety Fund System briefly discussed above. Before
the FDIC was created, there were numerous state-organized insurance
schemes. Before the Civil War, in addition to New York, Indiana, Iowa,
Michigan, Ohio, and Vermont organized such systems. These had different
designs, and whereas some can be described as successful (Indiana, Iowa,
and Ohio), others were not. Although deposits were not insured under the
national banking system, the National Bank Acts were followed by a halt
to state insurance programs for almost 50 years. After the Panic of
1907, however, some states again introduced deposit insurance programs,
notably Oklahoma, which was then followed by a number of other states,
including Kansas, Mississippi, Nebraska, North Dakota, South Dakota,
Texas, and Washington. All collapsed during the 1920s, when agricultural
prices fell (see Golembe 1960, Calomiris 1989, 1990).
During the national banking era, private bank clearinghouses in
various cities undertook the role of monitoring banks, and in the Panics
of 1893 and 1907 they provided a kind of insurance. When suspension of
convertibility occurred, organized by the clearinghouse, the
clearinghouses would not exchange currency for checks. But they did
issue clearinghouse loan certificates, in small denominations that could
be used as money, in both 1893 and 1907. These certificates were the
joint liability of all members of that clearinghouse that were located
in its city. Thus, claims on an individual bank that might be insolvent
were replaced with claims on the group of banks (see Gorton and
Mullineaux 1987, Gorton 1985).
To summarize, after the Civil War, collateral backing by specified
eligible bonds under the National Bank Acts solved the problems with
bank notes but left demand deposits vulnerable to panic. The problem of
demand deposit panics was solved only in 1934 with the creation of
federal deposit insurance.
IV. Some Proposals for the Regulation of Shadow Banking
Our proposals are based on two themes developed in the paper:
--An important cause of the recent panic was that seemingly safe
instruments like MMMF shares and triple-A-rated securitized bonds
suddenly seemed unsafe. New regulation should seek to make it clear,
through either insurance or collateral, which instruments are truly safe
and which are not.
--The rise of shadow banking was facilitated by a demand-driven
expansion in the bankruptcy safe harbor for repos. This safe harbor has
real value to market participants and can be used to bring repos under
the regulatory umbrella.
We use these themes to develop our specific proposals for MMMFs,
securitization, and repos.
IV.A. MMMFs: Narrow Savings Banks or Floating Net Asset Values
The central regulatory problem for MMMFs is simple: MMMFs compete
in the same space as depository banks, but differ from them in providing
an implicit promise to investors that they will never lose money. This
promise, for which the MMMFs do not have to pay, was made explicit by
the government in the recent crisis. This problem is well understood and
has been discussed for many years by academics and regulators. To solve
it, we adopt the specific proposal of the Group of Thirty (2009), which
is concise enough that we quote it in full:
a. Money market mutual funds wishing to continue to offer bank-like
services, such as transaction account services, withdrawals on demand at
par, and assurances of maintaining a stable net asset value (NAV) at par
should be required to reorganize as special-purpose banks, with
appropriate prudential regulation and supervision, government insurance,
and access to central bank lender-of-last-resort facilities.
b. Those institutions remaining as money market mutual funds should
only offer a conservative investment option with modest upside potential
at relatively low risk. The vehicles should be clearly differentiated
from federally insured instruments offered by banks, such as money
market deposit funds, with no explicit or implicit assurances to
investors that funds can be withdrawn on demand at a stable NAV. Money
market mutual funds should not be permitted to use amortized cost
pricing, with the implication that they carry a fluctuating NAV rather
than one that is pegged at US$1.00 per share.
The logic of this proposal--the elimination of "free"
insurance for MMMFs--seems powerful. So why has it not been adopted? One
reason is that the MMMF industry is reluctant to part with free
insurance, and a $4 trillion industry can make for a powerful lobby. A
second reason is that 2010 still seems a dangerous time to be disrupting
such a large short-term credit market. We certainly are sympathetic to
this second reason, but we believe that any changes can be decided now
and implemented after the credit markets have recovered.
Our only tweak on the Group of Thirty proposal is that we call
their special-purpose banks "narrow savings banks," or NSBs.
We do this to underline the analogy to our "narrow funding
banks" (NFBs) for securitization, as described in the next
IV.B. Securitization: Narrow Funding Banks
The basic idea of NFBs is to bring securitization under the
regulatory umbrella. What may seem radical at first glance becomes less
so when it is recognized that securitization is just banking by another
name, and that it makes sense to regulate similar functions with similar
rules. Indeed, the logic is the same as that for the creation of NSBs in
place of MMMFs. NFBs would be genuine banks with charters, capital
requirements, periodic examinations, and access to the Federal
Reserve' s discount window. Under the proposal, all securitized
products must be sold to NFBs; no other entity would be allowed to buy
ABSs. (NFBs could also buy other high-grade assets, such as U.S.
Treasury securities.) NFBs would be new entities located between
securitizations and final investors. Instead of buying ABSs, final
investors would buy the liabilities of NFBs.
An NFB regulator would design and monitor the criteria for NFB
portfolios. It would determine what classes of ABSs are eligible for
purchase by NFBs and would determine the criteria governing the allowed
proportions of different asset classes in the portfolio and the
proportions of assets of different ratings. With these rules, the
regulator would be setting collateral requirements for NFBs in the same
way that the National Bank Acts set collateral requirements for bank
notes in the 19th century, and in the same way that bank regulators set
capital requirements in the 21st century.
Note that under the Group of Thirty's proposal, the government
would offer explicit government insurance for what we are calling NSBs,
just as it does today for depository banks. Such insurance would be
workable for NSBs because all holdings of these banks would have the
same seniority, and the entire portfolio would be required to have low
risk. Securitization is different. Because ABSs typically have multiple
tranches, we do not believe that insurance would be a practical
solution: the subordinated components would have some risk and could not
be insured, and insurance on the senior components would exacerbate the
information problems in the subordinated components. It would defeat the
purpose of our proposed regulatory structure to create a new form of
government guarantee only to create a new form of adverse selection.
Thus, we have proposed collateralization combined with supervision, but
we acknowledge that this combination cannot provide the same 100 percent
protection as government insurance. For that reason NFB liabilities can
never be considered perfect substitutes for government debt, and the
Federal Reserve would need to ensure a sufficient supply of non-NFB
collateral. We return to this important point in section V.
Our proposal does place new burdens on the regulatory system. The
NFB regulator would have to monitor NFB portfolios and perhaps take
corrective action. Would it be up to the task? We believe that this task
is no different from that faced by traditional bank regulators. The NFB
regulator would need to assess the risks of each NFB's activities
and evaluate the amount of capital it needed. If the regulatory system
is incapable of performing this activity for NFBs, it will be equally
challenged if these activities remain on the balance sheets of
NFBs would be a different category of bank because their activities
would be so narrowly circumscribed; they would be rules-driven,
transparent, stand-alone, newly capitalized entities that could buy only
ABSs and other low-risk securities and issue liabilities. They would not
be allowed to take deposits, make loans, engage in proprietary trading,
or trade derivatives. These limitations would result in a much lower
risk profile than traditional banks have, with lower earnings volatility
and a much lower return on equity. (26)
NFBs can be viewed as regulated collateral creators or repo banks.
They would be allowed to fund themselves through repos. They could
engage in repo transactions with private depositors, as could other
entities as discussed below. Since all ABSs would have to be sold to
NFBs, NFBs would subsume the function of ABCP conduits, SIVs, and
related limited-finance companies. These other entities could become
NFBs but would have to sever ties with bank sponsors and meet the other
NFB requirements. NFBs would therefore complement traditional
banks' origination and securitization activities. As in the
precrisis economy, traditional banks could fund loans through
securitization, but the resulting ABSs would have to be purchased by
IV.C Repos: Licenses, Eligible Collateral, and Minimum Haircuts
There are two sides to a repo contract: the depositor, who provides
cash to the bank in exchange for interest and receives collateral (the
transaction is a "reverse repo" from the depositor's
perspective), and the bank, which receives the money and initially holds
the bonds used as collateral. In the crisis the problem was that the
housing price shock caused securitized products to become
information-sensitive, leading to withdrawals from the repo market,
which in turn forced banks to liquidate collateral. This would suggest
that we focus our proposals for new regulation on the banks, the
providers of collateral, rather than on the depositors. Indeed, we want
to provide a safe, deposit-like account for the bulk of repo depositors.
The problem is that, as discussed above, repos have many other uses as
well, including the short selling of bonds for hedging purposes and the
conducting of arbitrage to keep derivative prices in line with prices on
the underlying assets. So any regulation of repos must make them safe
for depositors while at the same time allowing for these other uses.
This is the basis for our repo proposal, which distinguishes the
treatment of banks from that of other entities that can use repos:
--Banks (NFBs, NSBs, and commercial banks) would be allowed to
engage in repo financing, that is, the activity of borrowing money,
paying interest, and providing collateral.
--Nonbank entities would also be allowed to engage in repos, but
only with a license, and would face other constraints as discussed
--Eligible collateral for banks in repo transactions would be
restricted to U.S. Treasury securities, liabilities of NFBs, and such
other asset classes as the regulator deems appropriate.
--Eligible collateral for nonbank entities could be any type of
security, but the transaction would be subject to minimum haircuts and
position limits as specified below.
--Minimum haircuts would be required on all collateral used in
repos and could be specific to the two parties and the collateral
--Position limits would be set for nonbank entities, in terms of
gross notional amounts issued or held, as a function of firm size and
the collateral used.
--Rehypothecation would be limited automatically by the minimum
Eligible collateral for banks would be any bond that the regulators
approve for their portfolios; this would include approved ABSs,
government bonds, and possibly the debt of government-sponsored
entities. As with the regulations on NFBs, the rules for eligible
collateral would be analogous to 19th-century rules for collateral on
Because of position limits and possibly higher minimum haircuts,
repos outside of banks would be constrained. The advantage thus
conferred on being a bank would keep this type of money creation mostly
within the regulated sector but would not prevent the use of repos for a
broader range of purposes other than as a deposit.
NFBs would not be required to finance all, or even part, of their
portfolios using repos. Indeed, we would expect that NFBs would issue
some longer-term debt, for purchase by institutional investors, and use
some repo financing as well, with the relative proportions determined by
supply and demand.
Nonbank licensed entities allowed to engage in repos would include,
for example, hedge funds, which have usually financed themselves in the
repo market. In doing so they would be borrowing against securities
posted as collateral; they would not act as repo depositors. On the
other side of the transaction would be a bank or other entity lending
against the collateral and possibly borrowing from a third entity
against this same collateral.
If none of these three entities is a bank, position limits with
regard to total repos outstanding (regardless of direction) on each of
the three entities would constrain this type of transaction. Haircuts
would depend on the identities of the parties to a repo, in a bilateral
repo, and on the type of collateral. Minimum haircuts may not be binding
on some transactions, but they are likely to be meaningful because of
the restriction to eligible collateral. Minimum haircuts would not
prevent all runs: they would, however, limit leverage and reduce
In summary, our proposed rules would create two types of allowable
repo. The first type, offered by commercial banks and NFBs, would
capture the monetary function of repos and would be regulated in a
manner analogous to the regulation of bank notes (with regard to
collateral) in the 19th century and depository institutions in the 21st
(using minimum haircuts as an analogue to capital requirements). The
second type could be offered by any institution with a license and would
be regulated so as to be more expensive than the first. Policymakers and
the judiciary could prevent a third type, totally unregulated repos, by
making clear that only the first two types receive the special
bankruptcy protections. The repo market owes much of its existence to
these protections; by offering them only to regulated repos, leakage
from the regulated system could be minimized.
Repos and securitization should be regulated because they are, in
effect, new forms of banking, but with the same vulnerability as other
forms of bank-created money. Like previous reforms of banking, our
proposals seek to preserve banking and bank-created money but eliminate
bank runs. Our proposals are aimed at creating a sufficient amount of
high-quality collateral that can be used safely in repo transactions.
NFBs would be overseen to ensure the creation of safe collateral, and
repos would mostly be restricted to banks. Our proposals are built on
the idea that these activities are efficient, in part because of the
safe harbor from bankruptcy, the maintenance of which is the incentive
for agents to abide by the proposed rules.
As we showed in section III, the vulnerability of bank-created
money to banking panics has a long history, and the history of attempts
to eliminate this problem is almost as long. Collateralization has been
one successful approach. Off-balance-sheet banking has become the major
source of collateral and needs to be overseen. We propose that NFBs
become the entities that transform ABSs into government-overseen
collateral. Repos then can be backed by this high-quality collateral.
In this paper we have not provided all the details necessary for
determining acceptable collateral or for setting minimum haircuts. These
details would need to be worked out in conjunction with rules for bank
capital, with which they would be closely intertwined. Although it is
clear that setting rules for shadow banking would make new demands on
regulators, these demands would be analogous to those that arise when
setting rules for banks. Whether risks are retained on the balance sheet
or allowed to go off the balance sheet, there is no escaping the need
for regulators to evaluate these risks. We do not see any pure private
sector solutions to ensure the safety of the banking system, and so the
role of regulators will remain essential. If today's regulators are
found not to be up to the task, they should be better trained and better
paid. If instead the task is simply impossible, then either we are
destined to have more crises, or we will be forced to live with a
greatly constrained financial system.
Space constraints prevent us from discussing a number of important
related issues, but we will close by briefly focusing on two. The first
is whether our proposals would lead to a shortage of suitable
collateral, as apparently has happened in the past. As the crisis
showed, if the volume of U.S. Treasury securities outstanding is
insufficient for use as collateral, the private sector will have an
incentive to try to create substitutes, such as triple-A-rated bonds.
The problem is that the substitutes cannot always be
information-insensitive. In 2005 the idea of the U.S. Treasury providing
a backstop facility, a "securities lender of last resort," was
broached (see Garbade and Kambhu 2005, U.S. Treasury 2005). Our view is
that such a facility might need to be available on a regular basis, but
that it should be run by the Federal Reserve, which might also need to
issue its own securities to be used exclusively as repo collateral. The
Federal Reserve needs to focus more carefully on the provision (and
measurement) of liquidity, and it is the job of the Fed to provide
A second issue concerns monetary policy generally. Because no
measure presently exists of the whole of the repo market, we do not know
its full size or the extent of rehypothecation. It seems that U.S.
Treasury securities are extensively rehypothecated (Krishnamurthy and
Vissing-Jorgensen 2010) and therefore should be viewed as money. This
means that open market operations are simply exchanging one kind of
money for another, rather than exchanging money for "bonds."
Open market operations may need to be rethought.
Glossary of Shadow Banking Terms
Asset-backed commercial paper (ABCP): Short-term debt issued by a
bankruptcy-remote special purpose vehicle, or conduit, which uses the
proceeds to purchase asset-backed securities. Such vehicles are set up
by a bank or other sponsor but owned and actively managed by a
management company legally separate from the sponsor. See Fitch Ratings
Asset-backed security (ABS): A bond backed by the cash flows from a
pool of specified assets in a special purpose vehicle rather than by the
general credit of a corporation or other entity. The asset pool may
contain residential mortgages, commercial mortgages, auto loans, credit
card receivables, student loans, aircraft leases, royalty payments, or
any of a variety of other types of asset.
Collateralized debt obligation (CDO): An instrument issued by a
special purpose vehicle that buys a portfolio of fixed-income assets,
financing the purchase by issuing CDOs in tranches, whose risk ranges
from low (senior tranches, rated triple-A) through medium (mezzanine
tranches, rated double-A to Ba/BB), to high (equity tranches, unrated).
Rehypothecation: In the repo context, the right to freely use the
bonds received as collateral for other purposes.
Narrow funding bank (NFB): A proposed new type of bank that may buy
only asset-backed securities and certain other high-quality assets, as
approved by a regulator. The regulator sets the portfolio criteria with
respect to the proportions of asset types and their ratings. NFBs would
be able to issue any nondeposit liability and would have access to the
discount window but could not engage in other activities. As regulated
banks, NFBs would have charters, capital requirements, and regulatory
Narrow savings bank (NSB): A proposed new type of insured
depository institution into which existing MMMFs seeking deposit
insurance protection could be transformed. As insured entities, NSBs
would have charters, capital requirements, and regulatory examinations.
Sale-and-repurchase agreement (repo): A contract in which an
investor places money with a bank or other entity for a short period and
receives (and takes physical possession of) collateral valued at market
prices, as well as interest. The bank or other entity simultaneously
agrees to repurchase the collateral at a specified price at the end of
the contract. From the perspective of the bank, the transaction is a
"repo," and from the perspective of the depositor, the same
transaction is a "reverse repo."
Securitization: The process of financing a portfolio of loans by
segregating specified cash flows from those loans and selling securities
in the capital markets that are specifically linked to those flows. The
firm originating the loans (the "sponsor") sets up a special
purpose vehicle to which it then sells the specified cash flows, and
which issues the (rated) linked securities. The sponsor continues to
service the cash flows; that is, it makes sure that the cash flows are
arriving and performs certain other tasks associated with traditional
Special purpose vehicle (SPV): An SPV (also called a special
purpose entity, SPE) is a legal entity set up for a specific, limited
purpose by a sponsoring firm. An SPV can take the form of a corporation,
trust, partnership, or limited liability company, but it is not an
operating company in the usual sense. It has no employees or physical
location and is strictly bound by a set of rules so that it can only
carry out some specific purpose or circumscribed transaction, or a
series of such transactions. An essential feature of an SPV is that it
is "bankruptcy remote," that is, incapable of becoming legally
bankrupt and unaffected by the bankruptcy of its sponsor. See Gorton and
Tranche: From the French for "slice," a portion of a
portfolio ordered by seniority and sold separately from other portions;
for example, a triple-A-rated tranche is more senior than a
triple-B-rated tranche of the same portfolio.
ACKNOWLEDGMENTS We thank Stefan Lewellen, Marcus Shak, and Lei Xie
for research assistance; Darrell Duffle, Victoria Ivashina, Robert
Merton, Stephen Partridge-Hicks, Eric Rasmusen, Nicholas Sossidis, David
Scharfstein, Andrei Shleifer, Carolyn Sissoko, Jeremy Stein, Phillip
Swagel, David Swensen, Daniel Tarullo, the editors, participants at the
Brookings Panel conference, and seminar participants at MIT for many
helpful comments and discussions; E. Philip Davis, Ingo Fender, and
Brian Reid for assistance with data; and Sara Dowling for help with the
Gary Gorton was a consultant to AIG Financial Products from 1996 to
2008. Andrew Metrick served in the Obama administration during the
debate and passage of the Dodd-Frank legislation. In addition, he has
served as a consultant for various financial institutions.
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(1.) Some of the important shadow banking terms are defined later
in the paper and in the appendix. In other work (Gorton and Metrick
2010, forthcoming), we refer to the specific combination of repos and
securitization as "securitized banking." Since this paper
takes a broader view to include activities beyond repos and
securitization, we use the more common but less precise term
(2.) This power, crucial for the future regulation of shadow
banking, is granted in section 120 of the Dodd-Frank legislation.
Although any new regulations cannot exceed current statutory authority,
this authority would still allow for significant new regulation of
MMMFs, repos, and securitization without the need for new legislation.
(3.) As we discuss later, repos are carved out of the Chapter 11
bankruptcy process: They are not subject to the automatic stay rule. If
one party to the repo transaction fails, the other party can
unilaterally terminate the transaction and keep the cash or sell the
bond, depending on which side of the transaction that party has taken.
(4.) The "information-sensitive" and
"information-insensitive" nomenclature comes from Dang,
Gorton, and Holmstrom (2010a, 2010b).
"Information-insensitive" roughly means that the cost of
producing private information about the payoff on the security is not
worth bearing by potentially informed traders. Such securities do not
face adverse selection when sold or traded. But a crisis occurs when a
shock causes production of such private information to become
(5.) The Group of Thirty (2009) proposal uses the term
"special purpose banks" for what we call "narrow savings
banks" for terminological consistency with other parts of our
(6.) These changes have been much noted and much studied, so we
only briefly review them here. See Keeley and Zimmerman (1985), Bryan
(1988), Barth, Brumbaugh, and Litan (1990, 1992), Boyd and Gertler
(1993, 1994), Edwards and Mishkin (1995), and Berger, Kashyap, and
Scalise (1995), among many others.
(7.) MMMFs are registered investment companies that are regulated
by the SEC in accordance with Rule 2a-7, adopted pursuant to the
Investment Company Act of 1940.
(8.) This description of securitization and SPVs is based on Gorton
and Souleles (2006).
(9.) See Klee and Butler (2002) for some details on how SPVs are
structured to avoid bankruptcy.
(10.) The LTV Steel case (In re LTV Steel, Inc., No. 00-43866, 2001
Bankr. LEXIS 131 (Bankr. N.D. Ohio Feb. 5, 2001)) threatened the
bankruptcy remoteness concept, but the parties settled before a court
decision was handed down, and the parties agreed that there had been a
"true sale" of the assets to the SPV. Although the outcome was
ambiguous, it did not hamper the growth of securitization. There have
been no other cases challenging bankruptcy remoteness. See, for example,
Kettering (2008), Schwarcz (2002), and Stark (2002).
(11.) This process is documented by Keeley (1990), Gorton and Rosen
(1995), Demsetz, Saidenberg, and Strahan (I 996), Galloway, Lee, and
Roden (1997), and Gan (2004), among others.
(12.) Another important change occurred in 1999, when Congress
passed the Gramm-Leach-Bliley Act. This act permitted affiliations
between banks and securities firms; it created a special type of bank
holding company, called a financial holding company, which is allowed to
engage in a wider range of activities (such as insurance underwriting
and merchant banking) or under less stringent regulations (for example,
on securities underwriting and dealing) than traditional bank holding
companies. Before then, the ability of banks to engage in such
activities had been strictly constrained by the 1933 Glass-Steagall Act
and the Bank Holding Company Act of 1956.
(13.) The recent allegations about the Goldman Sachs Abacus
transactions (see the SEC complaint at Securities and Exchange
Commission v. Goldman Sachs & Co. and Fabrice Tourre,
www.sec.gov/litigation/complaints/2010/comp21489.pdf) concern synthetic
CDOs, not traditional securitization. Synthetic securitizations were not
(14.) Indeed, Morgan (2002) provides evidence that banks are more
opaque than nonfinancial firms.
(15.) See, for example, Johnson (1997) and Schroeder (1996). The
safe harbor provision for repo transactions was recently upheld in a
court lawsuit brought by American Home Mortgage Investment Corp. against
Lehman Brothers. See Schweitzer, Grosshandler, and Gao (2008).
(16.) Rehypothecation creates a multiplier process for collateral,
similar to the more familiar money multiplier. Since there are no
official data on repos, the size of this multiplier is not known.
Fegatelli (2010) looks at this issue using data from Clearstream, a
Luxembourg-based clearinghouse. See also Adrian and Shin (2008), who
link the use of repos to monetary policy.
(17.) The amendment was motivated by the Lombard-Wall decision (see
Lombard-Wall, Inc. v. Columbus Bank & Trust Co., No. 82 B 11556
(Bankr. S.D.N.Y. 1982)), which held that an automatic stay provision
prevented the depositor who held the collateral from selling the
collateral without court permission. See, for example, Garbade (2006)
and Krimminger (2006).
(18.) It is not clear that actual market practice was limited to
this set of securities. In fact, the evidence is that it was not. For
example, according to Liu (2003), "In recent years market
participants have turned to money market instruments, mortgage and
asset-backed securities, corporate bonds and foreign sovereign bonds as
collateral for repo agreements." No court cases have tested this.
(19.) See Krimminger (2006), Garbade (2006), Smith (2007), Sissoko
(2010), Johnson (1997), Schroeder (1996), and Waiters (1984).
(20.) Federal Reserve Flow of Funds data cover only the U.S.
primary dealers and thus show an even lower figure than the Federal
Reserve's other numbers.
(21.) "Double counting" refers to counting both repo and
reverse repo (see the appendix) in the same transaction. The extent of
this issue is unclear, as no data exist on the extent of involvement of
nonfinancial firms in repos: only financial firms have been counted,
estimated, or surveyed. Again, anecdotally, many nonfinancial
firms" treasury departments (for example, Westinghouse, IBM, and
Microsoft) invest in repos, as do institutional investors and states and
municipalities, as discussed above.
(22.) Among many others, Brunnermeier (2009), Adrian and Shin
(2010), Krishnamurthy (2010), He, Khang, and Krishnamurthy (2010),
Gorton and Metrick (2010a, 2010b), and Gorton (2010) document and
analyze the crisis. Some examples of theory-oriented papers are Acharya,
Gale, and Yorulmazer (2009), Bmnnermeier and Pedersen (2009),
Geanakoplos (2009), Dang, Gorton, and Holmstrom (2010a, 2010b), He and
Xiong (2009), Pagano and Volpin (2009), Shleifer and Vishny (2009),
Uhlig (2009), and Martin, Skeie, and von Thadden (2010).
(23.) For a history of U.S. banking before this period, see, among
others, Knox (1900).
(24.) We focus here on New York, which was the most important state
in this history in many ways. For more general treatments, see, for
example, Dewey (1910), Golembe (1960), and Rockoff (1974).
(25.) Connecticut, Florida. Illinois, Indiana. Iowa. Louisiana,
Massachusetts, New Jersey, Ohio, Pennsylvania, Tennessee. Vermont,
Virginia. and Wisconsin adopted free banking laws before the Civil War.
(26.) For greater concreteness we provide an abbreviated sample
term sheet indicating the main features of a NFB at the Brookings Papers
website. As the sample term sheet indicates, if capital or other
triggers are hit. the NFB would automatically go into a limited,
"no growth mode," and if it does not recover, it would
automatically go into wind-down, in a process we call "natural
amortization." This would be a form of living will governing all
the points of transition between operating states. There would be no
bailouts of NFBs.
Comments and Discussion
ANDREI SHLEIFER This fascinating paper by Gary Gorton and Andrew
Metrick provides an extremely useful overview of the shadow banking
system, puts it into historical perspective, explains how it is
responsible for the financial crisis, and makes a proposal for how to
fix it. Yet the paper is much more than an overview, and in some crucial
ways it provides a highly distinctive perspective. This perspective
consists of four propositions.
First, starting with the widely accepted notion that the defining
feature of the shadow banking system is securitization, the paper goes
on to argue that the essential aspect, indeed the raison d'etre, of
securitization is maturity transformation, that is, the transformation
of long-term financial instruments, such as mortgages, into short-term
securities, such as repos and commercial paper. Securitization became so
massive, in the authors' view, not so much to create allegedly safe
long-term securities through diversification and the tranching of risky
debt, as many economists have argued, but rather to use these securities
to provide fodder for short-term finance. Long-term securities, in this
view, served mainly as collateral for short-term borrowing instruments.
It is the demand for short-term securities from money market mutual
funds and other short-term investors that made securitization possible.
Second, the paper argues that the abrupt withdrawal of short-term
finance was responsible for the financial crisis. Because investors in
short-term securities expected complete safety, the realization that
these securities might be at risk caused them to withdraw financing on
very short notice. This withdrawal took the form of rapidly rising
haircuts on repo transactions or even runs. When the dealer banks that
engineered the maturity transformation faced this withdrawal of
short-term finance, they had to liquidate the positions they had
financed with short-term debt, triggering massive losses, declines in
their balance sheets, and reductions in their ability to finance either
their existing holdings or other investments.
Third, among the several different forms of short-term finance
associated with the maturity transformation, the real culprit for the
increase in financial fragility, in the authors' view, is the repo.
Repo financing of asset-backed securities (ABS) holdings was
particularly aggressive because by law repos are bankruptcy remote: the
parties extending such collateralized finance do not become part of the
bankruptcy estate should the borrower default. Such regulatory
protection of repo finance, Gorton and Metrick maintain, caused it to
grow to gigantic levels. Its withdrawal, or the sharp increase in its
cost, is therefore primarily responsible for the crisis.
Fourth, in the light of the above three points, the paper argues
that the route to financial stability is to regulate repo financing of
ABS holdings. This would be done by, first, forcing all ABSs to be rated
by a government-regulated agency and sold to specialized narrow banks;
second, restricting the quantity of ABSs that can be financed with repos
and the terms of that financing; and third, more closely regulating the
lenders in the repo market, particularly the money market mutual funds.
As I explain below, all four of these distinctive propositions are,
to varying degrees, controversial. I am not suggesting that I know that
they are wrong. Rather, my goal is to point out that information is
extremely limited even today about exactly who were the various buyers
of ABSs, what was the extent of maturity transformation, and even what
were the main sources of financial fragility. We do know by now that the
Federal Reserve did not collect the information that would today, 2
years later--let alone in 2008--enable us to answer these questions with
confidence. We also know that neither the Federal Reserve nor many of
the major market participants, such as AIG and Citibank, understood the
vulnerability of shadow banking at the time of the crisis. What really
happened is still largely a matter of guesswork. It may well turn out
that Gorton and Mettick's assessments are correct, and then in
retrospect they will look like geniuses, but my intention is to identify
the areas of extreme uncertainty in our knowledge today.
To begin, the fundamental assumption of the Gorton and Metrick
narrative is that securitization was, to a first approximation, all
about providing fodder for short-term riskless finance. For this to be
the case, it must be that nearly all ABSs, or at least the lion's
share, were financed short-term by their holders. It is surely the case
that a good deal of ABSs went into structured investment vehicles (SIVs)
or were held by dealer banks themselves, and in these instances,
short-term finance was common. Yet at least some, and possibly a good
part, of ABSs were acquired by pension funds, insurance companies, and
even government-sponsored enterprises. For those buyers, short-term
financing was probably much less important. The reason this observation
is of some consequence is that Gorton and Metrick's regulatory
proposal would require that all ABSs be maturity transformed, which
presumably would prevent their being sold to investors in long-term
securities. I am far from certain that this would be desirable.
Gorton and Metrick's second assumption is that the withdrawal
of this short-term finance was responsible for the crisis. This
assumption seems plausible, since sharp reductions in short-term
financing did occur around the time of Lehman Brothers' failure,
but even here there are some issues. First, the reductions in short-term
financing of long-term positions in ABSs began in the summer of 2007, as
the market for asset-based commercial paper dried up. This withdrawal of
short-term financing was countered by several liquidity interventions
from the Federal Reserve, which successfully delayed the collapse of the
markets until the fall of 2008.
Second, and more important, it is far from clear whether the
withdrawal of short-term financing in August and September 2008 actually
precipitated the collapse or was, alternatively, its consequence. After
all, bad news about both housing and commercial real estate was coming
into the market throughout 2008, making it increasingly clear that
several of the major financial institutions were insolvent. Was the
withdrawal of short-term finance a response to this realization of
insolvency, or did it actually precipitate the insolvency? Following
Douglas Diamond and Philip Dybvig (1983), economists often use the term
"run" to describe a multiple-equilibrium situation, in which a
bad equilibrium with a run can occur despite solid fundamentals. Such a
run does not seem to be a good description of what happened to Lehman
and other banks in 2008. The withdrawal of short-term finance surely
undermined bank balance sheets, but it seems to me at least as plausible
that this withdrawal was a response to an already incurable situation
rather than its cause. And if that is the case, regulating short-term
finance might not be as high a priority as Gorton and Metrick indicate.
Gorton and Metrick's third assumption, namely, that repo
financing of ABSs was the source of instability in the financial system,
is the most controversial.
Dealer banks relied on a variety of short-term financing
mechanisms, including not only repo but also prime brokerage and
commercial paper. Prime brokerage enabled dealer banks to use the assets
they held on behalf of their brokerage clients as collateral for their
own borrowing. The withdrawal of those accounts was apparently extremely
costly to Bear Stearns and perhaps other dealer banks. Commercial paper
is, of course, the most traditional form of short-term financing and was
hugely important in the years before the crisis. Indeed, the SIVs, which
were the institutions most centrally involved in the maturity
transformation, financed themselves with commercial paper, and not with
repos. My figure 1, taken from Tobias Adrian and Hyun Song Shin (2010),
shows outstanding volumes of repos and commercial paper around the time
of the crisis. The two series show extremely similar patterns of
extraordinary growth before the crisis, followed by a rapid collapse.
How do Gorton and Metrick know that, even assuming that the withdrawal
of short-term finance in August and September 2008 was at the heart of
the crisis, it was repos rather than commercial paper that tipped the
balance? Lehman, after all, defaulted on its commercial paper. This
issue is critical since commercial paper is not an innovation but a very
old financial instrument (the Federal Reserve's 1913 charter gives
it responsibility for that market), and in particular it does not enjoy
the legal advantages with respect to bankruptcy that repos do. It would
seem a bit audacious to lay the blame on repos' bankruptcy
remoteness when commercial paper financing follows a nearly identical
pattern of growth and decline.
[FIGURE 1 OMITTED]
There are some further reasons to doubt that repos were the straw
that broke the camel's back. Most fixed-income repo financing uses
government or agency bonds as collateral. ABSs are used as collateral in
only a relatively small share of the repo market, and it seems highly
doubtful to me that repo financing of their own ABS holdings was
important for dealer banks. There is no evidence that the repo market in
government or agency paper malfunctioned badly during the crisis.
Moreover, many dealer banks are just intermediaries in repo financing:
they borrow securities from hedge funds and provide them with short-term
financing, and then lend these securities on to cash-rich, often
foreign, banks and borrow cash from them. So long as the dealer banks
can count on getting the hedge funds to cough up additional cash when
the haircuts on loans rise, the situation is stable. To elevate ABS
repos to the prominence in the crisis that Gorton and Metrick wish to
assign to it, they need to provide a good deal more evidence.
These reservations bring me to their policy proposal, which of
course would require a major regulatory overhaul of the whole shadow
banking system. Let me not focus on the question of whether, if the
underlying assumptions of the Gorton and Metrick analysis are correct,
their proposal would be a good idea. I understand that the Federal
Reserve Bank of New York considered a similar proposal a while ago and
decided against it because it was impractical. Let me instead come back
to the three assumptions.
First, if implemented, the proposal to allow only narrow funding
banks to purchase ABSs would deprive buyers of ABSs not interested in
short-term instruments of access to these securities. If', as the
authors believe, securitization reduces the cost of capital for
desirable investment projects, and if much of the demand comes from
investors uninterested in short-term finance of their positions,
shutting off this demand might not promote efficiency.
Second, if short-term finance was not the culprit during this
crisis, but instead the problem was, for example, the failure of
financial intermediaries to understand the risks of the securities they
were holding, it is not clear how the proposal addresses the central
problem. Would the world be a safer place if dealer banks maintained
large holdings of ABSs, or provided guarantees to SIVs, without relying
on short-term finance? Presumably, when these institutions are subject
to capital requirements and other regulations, they still face huge
pressure to shrink their balance sheets when they suffer losses.
Third, and perhaps most important, if ABS repos do occupy the
central position in the crisis to which Gorton and Metrick have elevated
them, then the singular focus on this market might leave the system as a
whole just as fragile as it was before. If the government raises the
cost of one form of short-term financing and does nothing else,
presumably the dealer banks will turn to other forms. I agree
wholeheartedly with Gorton and Metrick that the existing financial
infrastructure failed miserably during the crisis, but I would wish to
have a bit more confidence that we are wrecking and replacing the parts
of it that are actually rotten rather than the ones that are not.
In this regard, let me make one final point, to which I have
already alluded. It seems to me that the fundamental cause of the
financial crisis is that market participants, as well as the regulators,
did not understand the risks inherent in ABSs and other new types of
securities. They did not expect that home prices could tall so much and
so fast and in so many places at once. They did not understand
correlations in home prices and defaults. They used incorrect models. It
is not just the ratings agencies that messed things up, but the whole
market misunderstood the risks, as is clear from the fact that the price
of risk was extremely low in the summer of 2007 and did not rise much in
the months after that.
As long as market participants do not understand the risks of the
securities they are buying, whether these securities are ABSs or prime
money market fund shares or something that will be invented in the
future, and see profit opportunities in places where there are none, the
financial system will adjust to meet their demand (see Gennaioli,
Shleifer, and Vishny 2010). One implication of this is the standard
point that providing the intermediaries with bigger cushions of capital
and liquidity is desirable. But perhaps a deeper point is that in such
enviromnents where important risks are misunderstood, shutting down one
mechanism whereby investors and intermediaries pursue their profits is
unlikely to work. They will try to realize their dreams through other
instruments instead. Regulating a particular instrument, or a particular
segment of the market, to solve a more fundamental problem is highly
unlikely to work.
REFERENCES FOR THE SHLEIFER COMMENT
Adrian, Tobias, and Hyun Song Shin. 2010. "The Changing Nature
of Financial Intermediation and the Financial Crisis of 2007-2009."
Annual Review of Economics 2: 603-18.
Diamond, Douglas W., and Philip H. Dybvig. 1983. "Bank Runs,
Deposit Insurance, and Liquidity." Journal of Political Economy 91,
Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny.
Forthcoming. "Neglected Risks, Financial Innovation, and Financial
Fragility." Journal of Financial Economics.
DANIEL K. TARULLO Broadly speaking, threats to financial Stability
can arise in two Ways: first, through the rapid deterioration or failure
of a large institution with leverage sufficient to have widespread
knock-on effects, and second, through the breakdown of a significant
market in which large numbers of leveraged actors depend upon similar
sources of liquidity and, importantly, backup liquidity in periods of
stress. These two sources of systemic risk can be, and usually are,
related. In fact, the severity of the recent crisis might be explained
as an explosive combination of the two. But the different origins of
risk call for different or, perhaps more precisely, complementary,
policy responses. (1)
To date, reform in financial regulation and supervision has focused
mainly on large regulated institutions. Three examples are the
just-announced Basel III capital rules, much of the Dodd-Frank Act, and
the Federal Reserve's revamping of its supervision of large holding
Of course, attention has also been paid to the second source of
systemic risk, notably in Dodd-Frank's provisions for prudential
supervision of payments, clearing, and settlement systems. But more will
need to be done in this area, particularly as new constraints applicable
to large regulated institutions push more activity into the unregulated
This paper by Gary Gorton and Andrew Metrick fits squarely within
this enterprise. It builds on two important insights from work that
Gorton was pursuing well before the financial crisis began. The first
was that the enormous growth of the shadow banking system generally, and
the repurchase agreement, or "repo," market specifically,
depended on the engineering of triple-A-rated securities that led
participants to believe they did not need to inquire into the soundness
of the underlying collateral. This financial engineering largely
succeeded in insulating participants from idiosyncratic risk. But when
the value of whole classes of the underlying collateral was drawn into
serious question, initially by the collapse of the subprime housing
market, participants' lack of information about the collateral they
held led to a shattering of confidence in all the collateral.
In the absence of the regulation and government backstop that have
applied to the traditional banking system since the Depression, a run on
assets in the entire repo market ensued. The resulting forced sale of
assets into an illiquid market turned many illiquid institutions into
insolvent ones. The fallout has been such that, to this day, the amount
of repo funding available for nonagency residential mortgage-backed
securities, commercial mortgage-backed securities, high-yield corporate
bonds, and other instruments backed by assets with any degree of risk
remains substantially below its pre-September 2008 levels.
The second insight of Gorton's on which this paper builds is
the importance of statutory franchise value for the business model
viability of at least some kinds of regulated financial entities. Where
competition from unregulated entities is permitted, whether explicitly
or de facto, capital and other requirements imposed on regulated firms
may shrink margins enough to make them unattractive to investors. The
result, as in the past, will be some combination of regulatory
arbitrage, assumption of higher risk in permitted activities, and exit
from the industry. Each of these outcomes at least potentially
undermines the original motivation for the regulation.
Gorton and Metrick provide a concrete, although rather skeletal,
proposal to remedy the information problem in the repo market through
creation of statutory franchise value for what they call narrow funding
banks (NFBs). These banks would be "narrow" in that their only
assets would be asset-backed securities (ABSs) and very high quality
instruments such as Treasury securities. They would, it appears, make
their money from the income streams associated with the ABSs. They would
raise the funds to purchase ABSs through debt issuance and, most
significantly for the proposal, the repo market, in which the collateral
offered would be liabilities of the NFBs. The government would regulate
the NFBs directly, as it does all banks, but also by setting
requirements for the ABSs that could be bought by the NFBs. This
regulation is intended to provide market confidence in the liabilities
of the NFBs, which would be further buttressed by NFB access to the
A key feature of the proposal is that, by law, only NFBs could buy
securitized assets. The consequent franchise value would compensate NFBs
for the costs they incur because they can hold only high-quality
securities, are subject to supervision and prudential requirements, and
have to operate in a highly transparent fashion. In essence, ABS-backed
repo funding would be limited to NFBs.
The first two questions I would pose about this creative policy
proposal are the most basic: What problem is it supposed to solve, and
how does the breadth of the remedy align with that problem? Given their
analysis of the breakdown of the repo market, Gorton and Metrick's
answer might be self-evident: Their proposal aims to solve the
information problems that increased the risk from maturity
transformation associated with ABS repo funding. This, of course, is not
a solution for the entire shadow banking system, although an effective
plan for reforming the ABS repo market would be a major accomplishment
in itself. (2)
But the solution that Gorton and Metrick propose to this problem
would significantly restrict all asset-backed securitization. Although
it is obvious that too much credit was created through ABSs and
associated instruments in the years preceding the crisis, it seems at
least reasonable to question whether the best policy response is this
dramatic a change in the regulatory environment. One wonders, for
example, if it is desirable to forbid anyone but NFBs from buying ABSs,
particularly if there are investors interested in holding these assets
regardless of their utility in repo arrangements. The severe problems
now associated with ABSs began with assets held by mismatched entities
like structured investment vehicles or financial institutions engaged in
capital arbitrage under Basel II, not those held by end investors.
A variant on this initial question is how much the legal
environment for securitization should be changed in order to provide a
source of stable short-term liquidity in wholesale funding markets.
Limiting securitization purchases to NFBs would surely result in some
tailoring of ABSs to the business models of NFBs, an outcome that might
not be identical to a securitization market tailored to the funding
needs of lenders providing credit to businesses and consumers. Also, as
I will explain later, Gorton and Metrick's proposal would require
nontrivial changes in bank regulatory policy, as well as the significant
extension of discount window access to a new kind of institution. All
this would be in pursuit of a mechanism for generating large amounts of
liquidity. A cost-benefit discussion is probably needed at the outset,
with careful specification of the benefits of the repo market that the
authors are trying to save, weighed against the likely impact on, among
other things, the securitization market and the regulatory system.
A second set of questions concerns how the NFBs would operate in
practice. As a threshold matter, it is worth noting that policymakers
may find the proposal to have a certain binary quality. That is, it
would structurally change the entire securitization market and a large
portion of the repo market essentially overnight. In effect, Gorton and
Metrick put all securitization eggs into one basket. If the new system
worked well, the benefits presumably would be significant, and perhaps
Indeed, the new system might succeed in helping to restart, on a
sounder basis, various ABS submarkets that remain largely dormant 3
years after the crisis began to unfold. (3) If, on the other hand, the
new system encountered major difficulties, there might be materially
reduced adaptive capacity in other financial actors, possibly for a
One obvious source of difficulty is the possibility, well
recognized by Gorton and Metrick, that the business model mandated for
NFBs might not be viable and stable. Like all forms of narrow banks
proposed over the years, NFBs as a group would seem likely to generate
relatively low revenue, given the low risk of the securities in which
they would have to invest. Gorton and Metrick propose to counter this
problem by granting franchise value through the statutory monopoly on
securitization mentioned earlier and through access to the Federal
Reserve's discount window. Picking up on their analogy to the
creation of deposit insurance in the 1930s, the monopoly on
securitization is intended to help offset the regulatory costs imposed
on NFBs in the same way that the monopoly on the "business of
banking" was intended to offset the regulatory costs imposed on
insured depository institutions.
Unlike the business environment for banks in the 1930s, however,
securitization and repo lending are national, if not international,
activities, with little to suggest that any advantage would be derived
from local knowledge. It seems quite possible that the economies of
scale associated with the NFB model are sufficiently high that the
industry structure would tend toward oligopoly, or even monopoly. That
is, too much franchise value might be created. In that event there would
be significant additions to the cost side of the proposal's ledger,
in the form of the price and quantity effects that result from
noncompetitive industry structures.
Regardless of the eventual structure of the industry, NFBs
essentially would be monolines, with highly correlated risk exposures.
They could be particularly vulnerable to funding difficulties in times
of deteriorating credit conditions. Yet by the terms of Gorton and
Metrick's proposal, they apparently would not be able to hedge
interest rate or other risks. The authors propose giving NFBs access to
the discount window to forestall liquidity problems and runs on the
NFBs, presumably in the same way that deposit insurance stopped runs on
traditional banks. Here again, though, the analogy is not a perfect one.
Whereas banks and their depositors are assured that the Federal Deposit
Insurance Corporation will keep the latter whole in the event of the
former's failure, the Federal Reserve does not make binding
commitments to lend to any institution and actively discourages reliance
on the window for regular funding. In this regard, it is noteworthy that
the haircuts imposed on collateral presented at the discount window rose
during the recent crisis, although to a lesser extent than in the repo
A third question about the Gorton and Metrick proposal arises
because of the significant changes in current law and practice that it
would require. The prohibition on ABS holdings by anyone other than NFBs
is the obvious and major example. But there are several others. In
addition to the possibly problematic features of discount window lending
in general for the proposal, the Federal Reserve has traditionally
opened the window to nondepository institutions only in particularly
stressed conditions. Under the Dodd-Frank Act, any use of credit ratings
in federal regulations will be prohibited, an obvious complication to
the proposal. This part of DoddFrank has accelerated and expanded the
efforts already under way at the federal banking agencies to lessen
regulatory reliance on ratings. In truth, it may pose no greater
challenge for this proposal than for many existing capital rules. (4)
Still, it may require extension of the authors' confidence that the
regulator could adequately oversee ABS ratings to confidence that it
could assign ratings in the first place. I would observe that the
substantial effort expended by staff at the Board and at the Federal
Reserve Bank of New York to evaluate the creditworthiness of a
relatively small number of securitizations in the Term Asset-Backed
Securities Loan Facility (TALF) suggests the enormity of that task.
Furthermore, the wisdom of having a government agency--even the
independent central bank--assume such a permanent, central role in
credit allocation is at least subject to debate.
A final regulatory issue is raised by another feature of Gorton and
Metrick's proposal prompted by their expectation that equity
returns for NFBs will be lower than for traditional banks. In place of
the equity capital requirements generally applicable to banking
organizations, they propose that NFBs issue capital notes that would be
debt-like except in periods of stress, when they would convert to
equity. In essence, all of an NFB's capital would be contingent
capital. Although contingent capital is an item on the financial
regulatory agenda, it is considered a possible supplement to common
equity, not a substitute for it. In this respect, the proposal moves in
the opposite direction from Basel III, which has followed markets in
making common equity the centerpiece of capital evaluation and
These inconsistencies with current law and practice in the Gorton
and Metrick proposal do not themselves argue against its soundness. They
do, however, underscore the degree to which the NFBs would require
development of a new financial regulatory approach, as well as a
restructuring of the ABS and repo markets.
More generally, the existence of costs or problems with the
proposal is not sufficient grounds to reject it. In the face of very
real flaws in the precrisis state of these markets, and the failure of
some ABS markets to recover, even where it seems they could function
sensibly, there is a very good case for such a policy initiative. So let
me consider briefly whether variants on Gorton and Metrick's basic
approach might retain its core benefits while addressing some of its
One possibility would be to broaden the permissible ownership of
NFBs to include bank holding companies. This modification would make the
most sense if one believed that the proposal's basic approach was
promising but that the risks of either an untenable business model or
high industry concentration, and consequent anticompetitive effects,
were high. It is possible that a number of large, diversified financial
holding companies would find an NFB a viable part of their operations.
Gorton and Metrick would require, however, that NFBs be stand-alone
entities, and they would specifically prohibit ownership by commercial
banks, in an effort to avoid implicit contractual guarantees. This is a
legitimate concern, to be sure, but one that might be at least
imperfectly addressed through specific restrictions on relationships
between affiliates in a bank holding company. The relevant comparison is
thus between the residual costs of the regulated relationship and the
effects of an anticompetitive industry structure.
A second variant, also motivated by industry structure problems,
would be to turn NFBs from what in Gorton and Metrick's proposal
are essentially privately owned public utilities into actual public
utilities. However, the extent to which this change in ownership
structure would ameliorate the anticompetitive problems is uncertain.
Moreover, the concerns mentioned earlier with respect to government
judgments on credit allocation would remain, even if they are provided
another layer of insulation through the device of a government
corporation. In addition, of course, the history of Fannie Mae and
Freddie Mac is a cautionary tale of the potential for a government
monopoly with a conservative mandate to expand its operation into much
At first glance, then, it is not at all clear that structural
modifications to Gorton and Metrick's basic approach would be
preferable to the proposal as they have described it. Options that
depart from their approach would need to find different ways of solving
the information problems that they identify. Let me briefly note some
possible alternatives that would use regulatory requirements to create a
class of ABSs in which markets could, without inquiry into the nature
and quality of the underlying assets, have confidence even in periods of
stress. One way, of course, would be to follow more closely the deposit
insurance analogy by establishing an insurance system, a proposal that
Gorton and Metrick endorse with respect to money market funds. They
suggest, however, that an insurance system for securitization markets
would be impractical because of the existence of multiple tranches, at
least some of which would be uninsurable and thus would, in their view,
exacerbate rather than ameliorate information problems.
Another alternative would begin with an important idea that the
paper mentions, but which is not at the center of the proposal: making
the repo bankruptcy exception available only where the collateral
conforms to certain criteria established by law or regulation. Given the
demand for repo funding, it seems worth considering whether this device
could be used to create the franchise value necessary to sustain a
sizable wholesale funding market subject to safety and soundness
regulation. Indeed, if this approach has promise, it might be feasible
for a regulatory body to establish the requisite criteria without
providing insurance. With or without insurance, the "franchise
value" might attach more to the instrument than to an institution.
It is beyond the scope of this comment to enumerate the potential
difficulties with these ideas, but they are not hard to discern. In
common with the authors' proposal, they would require a level of
expertise and involvement in credit rating by the government that could
pose practical and, in some conceivable versions, policy concerns. In
any case, these are thoughts for further discussion, rather than
developed options. Gorton and Metrick have, in setting forth this
proposal, continued to shape our understanding of the role and risks of
the shadow banking system, while adding a specific proposal to our menu
of possible responses.
REFERENCES FOR THE TARULLO COMMENT
Board of Governors of the Federal Reserve System. 2010.
"Advance Notice of Proposed Rulemaking Regarding Alternatives to
the Use of Credit Ratings in the Risk-Based Capital Guidelines of the
Federal Banking Agencies." Joint Advance Notice of Proposed
Rulemaking. Washington (August 10). www.federal
reserve.gov/newsevents/pressPocregPocreg20100810a 1 .pdf.
Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky.
2010. "Shadow Banking." Federal Reserve Bank of New York Staff
Reports no. 458 (July).
(1.) The views presented here are my own and not necessarily those
of other members of the Board of Governors of the Federal Reserve System
or the Federal Open Market Committee. Tom King and Michael Palumbo of
the Board staff contributed to these remarks.
(2.) For a survey of the entire shadow banking system, see Pozsar
and others (2010).
(3.) The relative dormancy of these markets is also due in part to
the limited supply of the loans needed to feed the securitization
(4.) For a discussion of some of the issues raised in the context
of capital requirements, see Board of Governors of the Federal Reserve
(5.) It also seems likely that the kinds of quantitative liquidity
requirements currently under development by the Basel Committee on
Banking Supervision would be difficult for NFBs to satisfy.
GENERAL DISCUSSION Jonathan Parker noted that runs on highly rated
securities had also happened in money market mutual funds. Under current
regulation, the quality of a money market fund cannot easily be
discerned, and the structure of the fund gives fund managers little
incentive to become informed about the quality of highly rated assets.
Thus, there is often a trade-off between higher returns and an unknown
amount of additional risk. Given the short-term nature of these
investments, there is not only little incentive to gather information,
but often little time to gather it when it becomes clear that
information is needed. There is thus a trade-off in regulation between
liquidity--the speed with which money can be withdrawn (or not rolled
over)--and information creation. If something goes wrong and the asset
is withdrawable on demand or in the short term, I can get out, but I
will not be able to process whether that was the right decision. The
solution then seems to be to increase the terms of lending to promote
stability, so information can be gathered, but this comes at the cost of
liquidity. Parker also noted, with respect to the securitization model,
that there is no reason originators cannot be required to sell systemic
securitized risk to be insured against a macro crisis, while at the same
time holding the idiosyncratic risk of their loans for incentive
Robert Hall observed that the financial world has a thirst to hold
wealth with a zero probability of negative nominal return. The issue
raised by the paper is the value of creating institutions that cannot go
bankrupt. In a low-inflation economy, this issue of preventing negative
nominal returns is an important one, suggesting a simple change: rather
than raise inflation, depositors should get a lower return in exchange
for a lower probability of a negative return, while still allowing for
Kristin Forbes suggested that the paper was in effect saying that
the shadow banking system arose to compensate for shortcomings in the
bankruptcy system, and especially the length of time to resolve a
bankruptcy case. If that is so, one would expect that countries with
stronger bankruptcy regimes and faster bankruptcy resolution would have
smaller shadow banking systems. Do the cross-country data support this?
Her prior was that they did not. Countries such as the United States
have fairly strong and effective bankruptcy systems yet have the largest
shadow banking systems.
Phillip Swagel thought that Andrei Shleifer's concern over the
authors' proposal involving nationalization of the nonagency repo
market was misplaced. The proposal would remove some of the existing
legal protection for repo transactions that do not involve high-quality
collateral. Thus, it would reduce government coverage, not increase it.
This seemed to Swagel a reasonable way to provide an incentive for the
use of better collateral. On the other hand, there should be greater
understanding of the limits to which high-quality collateral matters.
The week alter Lehman Brothers failed, the U.S. Treasury offered
insurance for money market mutual funds. What was striking was that
essentially all of these funds--even those that invested only in
securities that were already government-guaranteed, such as Treasury and
agency bonds--chose to buy the insurance. These funds already had the
highest-quality collateral, yet it didn't matter; they wanted to
provide even more reassurance to investors. The lesson Swagel drew was
that in a true crisis, even the best collateral is not good enough.
Steven Davis argued that it was not obvious how the authors'
proposal flowed from their interpretation of the crisis. Excessive
leverage was what contributed in many ways to the crisis, facilitating
the housing bubble, among other things. Thus, the regulatory system
needs to be able to regulate leverage, for example through haircuts. For
Davis, this implied a different solution: that banks be required to hold
more capital, since the world is riskier than previously thought.
Ricardo Reis was interested in the idea of repos as a way around
bankruptcy. He raised three issues. First, in the cross section of
countries, do we see more use of repos (or similar instruments) in
countries with the least efficient bankruptcy procedures? Second, across
industries, are repos used more in industries where finances are more
opaque? And third, if the problem was the delays caused by bankruptcy
proceedings, why not reform the bankruptcy code?