No, it wasn\’t bank regulation that failed

One of the great things about Diamond-Dybvig is that it immediately punctures any superficial notion that a bank can be defined by some traditional appearance — that it basically has to be a marble building with rows of tellers, i.e. a depository institution. Any arrangement that borrows short and lends long, that offers investors claims that are liquid while using their funds to make illiquid investments is a bank in an economic sense — and is potentially subject to bank runs. Indeed, what we had in 2008 was mainly a run on shadow banks, on non-depository institutions.

It is much more accurate to say that non-bank, or shadow bank, regulation that failed.

Or even, that shadow banks didn\’t have deposit insurance and so were prone to liqudity problems…..

5 thoughts on “No, it wasn\’t bank regulation that failed”

  1. In his paragraph starting “First of all…” Krugman makes the classic mistake made by advocates of fractional reserve of thinking that full reserve constrains banks’ ability to lend because banks cannot create money. Obviously K is correct OTHER THINGS BEING EQUAL, in particular, given a constant money supply. But as Milton Friedman pointed out (indeed, this is no more than common sense), expanding the monetary base costs nothing. And expanding the monetary base (i.e. having more state produced money) makes up for private banks’ inability (under full reserve) to create money.

    In the paragraph after the above (starting “Second you would run…”) Krugman gets confused as to the difference between fractional reserve and maturity transformation. In this passage, which is supposedly dealing with fractional reserve, he says that a bank is an institution which borrows short and lends long. The latter activity is not fractional reserve: it is maturity transformation.

  2. mmm…but I thought that Northern Rock was basically a deposit -taker…and the other ghost UK banks (RBS, HBOS) had strong deposit-taking businesses that they bet on red in the casino.

  3. diogenes

    Sadly, no. Those banks had moved on well beyond mere deposit-taking. HBOS and NR were taking excessive risks in mortgage lending (lending long) funded by overnight interbank money (borrowing EXTREMELY short). They had astronomical loan to deposit ratios and very, very high leverage. They were relying on continuing rises in house prices to maintain collateral value to cover losses on their high-risk lending. Northern Rock’s TOGETHER loans default rate was 75% during the five months between its initial liquidity problems and its eventual nationalisation. That is indeed gambling, but not on a casino.

    RBS was involved in fraudulent mortgage origination in the US, for which it is being prosecuted, and in CDO investments which went very sour – that bit maybe could be regarded as “casino” gambling. But it also suffered serious losses in corporate lending (private equity and leveraged buyouts). And the final straw was the idiotic acquisition of ABN AMRO. Again, maybe gambling, but not on a casino.

    The myth that these banks failed because they gambled with depositors’ money on the international markets is just that, a myth.

  4. Wasn’t it laws passed under Clinton that forced banks to offer loans to people who would otherwise be considered bad risks?
    Are laws the same as regulations?
    And weren’t Fannie and Freddie forced to accept these bundled dodgy mortgages by regulations?
    It’s a great idea to have bank lending. Capital goes from those who can’t make it grow to those who can.
    Making it go to those who haven’t a clue and can’t pay it back is a bit daft, really. The laws and regulations said they must. With the consequences we’ve seen and which were predicted.

  5. thanks for the clarification Frances, b ut it njust leads me to conclude that there was a massive failure of regulation – especially in the case of NR

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