But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.
Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.
That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.
In recent years, the financial sector has increasingly found ways to evade those safeguards (generally with Washington's acquiescence) and a large portion of activity occurs outside of the commercial banking sector:
Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.
For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.
As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.
In fact, however, we were partying like it was 1929 — and now it’s 1930.
The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.
The Fed has responded by broadening its lender of last resort function to allow investment banks as well as commercial banks to borrow and to accept a wider range of securities (including mortgage backed securities) as collateral. The investment banks ("primary dealers") will be able to borrow from the new Primary Dealer Credit Facility (PDCF) - in essence, the Fed is opening the discount window to them. This comes in addition to the loans made available through the Term Securities Lending Facility (TSLF), announced the week before.
Although there are parallels with the banking crises of the 1930's, in the Times, Charles Duhigg explains that a repeat of the depression is unlikely. Partly this is because the structure of the economy has changed - in particular, government plays a much larger role in the economy now, acting as an "automatic stabilizer." Furthermore, economists (and policymakers) have learned some lessons, as evidenced the Fed's quick response (in his professor days, Ben Bernanke was a prominent scholar of the depression). [A minor factual error in the story: the highest unemployment rate of the postwar period was 10.8%, at the end of 1982].
Meanwhile, Congress is looking at updating regulation of the financial sector.