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Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007

53 Pages Posted: 18 May 2009  

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER)

Date Written: May 9, 2009

Abstract

The 'shadow banking system' at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms 'running' on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin ('haircut'), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic.

Keywords: financial crisis, banking panic, Panic of 2007, repo markets

JEL Classification: G01, G1, G12, G18, G21

Suggested Citation

Gorton, Gary B., Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007 (May 9, 2009). Available at SSRN: https://ssrn.com/abstract=1401882 or http://dx.doi.org/10.2139/ssrn.1401882

Gary Gorton (Contact Author)

Yale School of Management ( email )

165 Whitney Ave
P.O. Box 208200
New haven, CT 06511
United States

HOME PAGE: http://mba.yale.edu/faculty/profiles/gorton.shtml

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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