After listening to Yale finance economist Gary Gorton deliver a talk on “shadow banking” and the recent financial crisis, Randy Wright, a brilliant monetary theorist, was both perplexed and intrigued. Region readers may well have the same reaction after dipping into the following interview with Gorton.
Shadow banking—the intricate web of financial arrangements and techniques that developed symbiotically with the traditional, regulated banking system over the past 30 or so years—is territory Gorton has studied for decades, but it (and he) have been largely on the periphery of mainstream economics and policy.
That all changed in mid-2007, when panic broke out in the subprime mortgage market and financial institutions that support it. Expressions like “collateralized debt obligation” and “repo haircut” escaped the confines of Wall Street and business schools, and began to fill the airwaves. We’re still struggling to come to terms—and few are in a better position to help than Gorton…
Region: Why don’t we begin with some background on so-called shadow banking—the factors behind its enormous growth, and then its collapse during the financial crisis? Do you prefer a different term? You use “securitized banking” in some of your papers.
Gary Gorton: The term shadow banking has acquired a pejorative connotation, and I’m not sure that’s really deserved. So let me provide some context for banking in general.
Banking evolves, and it evolves because the economy changes. There’s innovation and growth, and shadow banking is only the latest natural development of banking. It happened over a 30-year period. It’s part of a number of other changes in the economy. And let me give even a little more context, historical context. I want to convince you that shadow banking is not a new phenomenon, in a sense—that we have had previous “shadow banking” systems in the past—and that there is an important structure to bank debt that makes it vulnerable to panic. So, the crisis is not a special, one-time event, but something that has been repeated throughout U.S. history.
Before the Civil War, banking involved issuing private money—that is, banks issued their own currency or bank notes. And this system worked in the way economists would expect it to work. The private bank money did not trade at par when it circulated any significant distance from the issuing bank. Instead, it was subject to a discount, so that a bank note issued by a New Haven bank as a $10 note might only be worth $9.50 at a store in New York City, for example.
Such discounts from par reflected the risk that the issuing bank might not have the $10—redeemable in gold or silver coins—by the time the holder took the note back to New Haven from New York. The discounts from par were established in local markets. But you can see the problem of trying to buy your lunch when the cook has to figure out the discount. It was simply hard to buy and sell things in such a world.