As a starting point, think about how a plain vanilla ordinary bank functions in the economy, acting as a financial intermediary between savers and borrowers. Here's a schematic taken from Chapter 29 of my Principles of Economics textbook (and of course, I encourage those teaching intro econ next year to check it out.) Savers deposit money in banks. Banks lend those funds to borrowers. Borrowers repay the loans with interest, and the original savers are paid some of that interest, along with having the ability to withdraw their money as desired.
But here's the potential problem. Once the money is loaned out, the borrowers are on a schedule to repay gradually over time. However, the original savers want the ability to withdraw their money any time they please. The assets of the bank (the loans it has made) are long-term, while the liabilities of the bank (the money it owes to savers) are potentially very short-term. In the textbook, I call this the "asset-liability time mismatch." Before the enactment of deposit insurance, if the original savers heard that their bank had made a lot of loans that might not pay off, they have an incentive to "run" on the bank, quickly withdrawing their deposits and bringing the bank to its knees. When the government started requiring deposit insurance, it knew that savers no longer had an incentive to monitor whether their bank was behaving prudently, and so the government also installed a system of bank regulation.
Sanches says it this way:
"This description of a typical banking crisis clearly reveals why banks are fragile: They fund illiquid assets with deposits that can be withdrawn at will. Economists usually refer to this practice as maturity transformation. It is important to mention that this role played by banks has a value for society. People have a preference for holding highly liquid assets — assets that are easy to sell without taking a loss — but the most profitable investments take a long time to pay off. Banks offer demand deposit contracts that give people ready access to their funds and a higher rate of return than they would get by holding liquid assets directly. Banks are able to offer a higher rate of return to depositors because they pool resources in such a way that permits them to invest a significant fraction of their assets in higher-yielding, long-term projects such as mortgages and other types of long-term loans. Normally, funding illiquid assets with short-term liabilities works fine. ButThe combination of deposit insurance and bank regulation worked to keep the U.S. financial system fairly stable for about 70 years from the late 1930s up to the start of the Great Recession. But during the last few decades, a new type of financial structure arose. Here's a schematic from Sanches showing how a shadow bank works:
when depositors begin to worry about losses, a bank run may ensue."
As he writes, step 1 is for the bank to make loans. However, in this case the bank does not wish to continue holding or servicing the loans, and so it sets up an SPV, or special purpose vehicle, which purchases the loans from the bank. Next, the special purpose vehicle issues asset-backed securities (ABS), which are just financial securities where the return is determined by the loans that the SPV purchased from the bank. Outside investors can buy these asset-backed securities.
There is nothing necessarily wrong with any of this. By selling off the loans to a special purpose vehicle, the bank insulates itself from the risk that loans might go bad. As a result, the bank regulators are pleased. The loans that are sold to the SPV might be home mortgages, or car loans, or money owed to credit card companies, or they might be loans to businesses, like the short-term loans called "commercial paper." Instead, the outside investors in the SPV bear that risk. Imagine, for example, that the outside investor is a large pension fund or insurance company, with long time horizons. The pension fund isn't set up like a bank to make business loans. But by purchasing a portfolio of such loans made through an SPV, the pension fund or insurance company can be well-positioned to bear the risk that some loans won't pay off, as long as on average it receives a solid return over time.
But several issues can arise in the new financial structure, as well. One risk is that that when banks know that they are not going to be holding the loans themselves, but rather selling the loans along to an SPV, they are likely to put less time and attention into evaluating the risk of the loans. The loans in an SPV may end up being riskier than expected, and if investors recognize that these risks are high, they will be less willing to invest in certain kinds of SPVs. In turn, if banks face a situation where it's hard for them to re-sell their loans to an SPV, and the banks have decided that they no longer wish to hold loans themselves, then the banks will cut back sharply on making loans in the first place.
Part of the credit crunch during the Great Recession was because investors became aware that at least some of the SPVs that included home mortgages were quite risky--but they didn't know which ones. As a result, they became unwilling to invest in any SPVs based on home mortgages for a time.
Another issue arises if those investing in the SPV are not an entity like a pension fund, with long-term time horizons and an ability to ride out the bumps in the market, but instead have very short-term time horizons. Imagine that you are running a corporation or a big financial organization like a pension fund, and you need to keep a certain amount of your money in cash, so that you can use it to pay bills and payroll. However, as Sanches points out: "Until 2011, large commercial depositors could not receive interest on their short-term deposits, another motivation for them to seek an alternative place to park their funds." When interest rates were very low, pension funds were searching for options to hold cash that paid a higher interest rate, too.
As a place to invest their liquid assets and still earn some return, these institutions turned to what's called the "repo" market, where repo is short for "repurchase." The market works this way. On one side you have parties who hold some financial assets, which could be Treasury bonds or mortgage-backed securities or car-loan-backed securities or something else. These institutions may often be investment banks or broker dealers. These institutions want to borrow some funds, and they offer the securities they hold as collateral. On the other side of the market, you have the big corporations and financial funds that are looking for a place to park their short-term cash and get some interest.
This is called the "repo" market because the financial transaction works this way: The investment bank or whoever owns the financial assets sell those assets to the corporation or financial fund, but part of the sale is an agreement to repurchase the asset at a slightly higher price the next day. The slightly higher price acts like an interest rate paid for borrowing. Now imagine that this transaction is repeated every day. The result is that the borrower has some amount that is continually being borrowed--that is, it is continually selling assets every day and buying them the next day. On the other side, the lender is receiving a steady stream of payments for their cash--that is, it is continually buying asset every day and reselling them, according to the repurchase contract, the following day. every day. It's a lot like a very strange bank, where every day all the depositors come and deposit their money, it is loaned out for one day, and at the end of the day all the depositors come and with draw their money--and this pattern is repeated every day. Sanches explains like this:
As should be clear by now, the “banker” in the repo transaction is the repo borrower, which typically is an investment bank or the broker-dealer arm of a large bank holding company. These institutions use the funds they borrow in the repo market to finance a wide range of activities, some of them quite risky. ... The growth of the repo market prior to the financial crisis of 2007-08 was extraordinary. The volume of repo transactions reported by primary dealers (those who trade directly with the Federal Reserve System) had grown from roughly $2 trillion in 1997 to $7 trillion in 2008. This estimate, of course, leaves out unreported transactions. ... [T]he overall size of the repo market just before the financial crisis was roughly the same as the size of theThe repo market may sound a little peculiar, but it works just fine--as long as the financial assets that are being bought and sold are extremely safe and secure, like U.S. Treasury borrowing. But in the years leading up to the financial crisis in 2007-2008, repo contracts began to be based more and more on other financial instruments, like mortgage-backed securities. In addition, financial funds like money market mutual funds, which are required by law to invest in short-term assets as a way of holding down their risks, began to put a portion of their funds into the very short-term repo markets.
traditional banking sector as measured by total assets. ...
As it became clear that mortgage-backed securities were not safe, those who had been putting the $7 trillion into the repo market backed away. Those who had grown to depend on being able to borrow that money--by rolling over the repo loans every day--found themselves rather suddenly without access to capital. Sanches explains this way:
"A depositor with serious doubts about the underlying value of the collateral can do two things: either ask for more collateral or simply not renew the repo. Both actions can be interpreted as a decision to withdraw funds from the shadow banking system, much like the decision bank depositors make to withdraw funds from their bank when they believe they might not be able to get all their money out. Repo lenders initially asked for more collateral, but ultimately they simply refused to renew their loans. In other words, the repo market froze Because investors could not tell safe MBS [mortgage-backed securities] from risky MBS in most cases, they withdrew their funds even from shadow banks that probably had safe MBS to secure repos. This problem was severe enough to turn the initial panic into a systemic event — a banking crisis. Thus, the financial crisis was not very different from the banking crises of old. Investors in the repo market behaved pretty much like bank depositors did during U.S. banking crises before 1933. And the outcome was certainly very similar. The initial banking crisis spread to other financial markets, and several financial firms either failed or had to be rescued by the federal government to prevent further failures."In broad terms, one way to think about these issues is that the old model of the plain-vanilla bank, making and holding loans, has been breaking down for some years now. Instead, there is a more complex web of investors in special purpose vehicles, often tied to banks if technically separate from them, who structure their financial transactions to have the overall effect of making deposits, lending, borrowing, and investing, but without having those actions happen in the organizational structure of a conventional bank. The task of creating a new structure of financial regulation to address the new realities is quite incomplete. The implementation of the Dodd-Frank financial reform legislation passed back in 2010 is only about half-completed, and for all the new requirements it seeks to impose, it does essentially nothing to address repo markets or issues of lending and borrowing financial securities.