Problems at commercial banks were not really at the center of the financial crisis of 2008, says John Cochrane, AQR Capital Management Professor of Finance. The genesis of the crisis was a "run" on the investment banks and short-term repurchase agreements, not commercial banks. The outstanding question is why this run translated into such a deep recession.
A common view of what went wrong during the crisis is that when the value of banks' capital eroded along with the steep fall in asset prices (especially mortgage-backed securities), banks were forced to sell assets, which pushed prices down further, causing "fire sales." Banks then hoarded funds and tightened lending because they were concerned about capital levels. According to this "institutional view," problems at commercial banks played a central role in the severity of the recession following the financial crisis.
But at a Deutsche Bank Speaker Series held at Harper Center on November 8, Cochrane argued that the economic repercussions of the crisis can be explained without emphasizing the role of intermediaries. In this "frictionless view," extreme movements in asset prices and a significant reduction in loans can be understood without pointing to a breakdown of commercial banks as the likely culprit.
Asset prices are typically high during good times but are followed by low returns, while prices are low in bad times but subsequent returns are high, Cochrane explained. While some people call this fact a "bubble," Cochrane pointed out that it can make sense because investors' appetite for risk naturally varies with the ups and downs of the business cycle.
"People chase yield in good times," said Cochrane. In such times, investors are happy to buy many assets and are willing to take on more risk despite "high" prices and low expected returns. Conversely, if there is a chance that people will lose their jobs, homes, or businesses in bad times, they may become more cautious about investing and pass up even very good opportunities that have low prices and high prospective returns. Thus, rather than a fire sale at commercial banks, the sharp and broad-based drop in asset prices during the crisis can make sense in the context of broader economic events.
Cochrane also is doubtful about a popular argument that banks stopped lending in order to preserve capital during the crisis. Capital constraints act as a wedge; this story presumes people still want to borrow and make new investments, and banks want to lend to them, but banks do not have enough capital to make the additional loans. However, a reduction in lending may also be due to shifts in the supply and demand for loans rather than a broken banking system. Banks may not see good investment opportunities, and people may not be eager to borrow. "Maybe people decided that a recession was coming and it was time to stop this huge consumption boom and start saving a bit," Cochrane said.
To tell the stories apart, Cochrane emphasized, people should look at the evidence. Borrowing indeed collapsed in mortgages and among consumers and businesses during the crisis. But commercial bank lending did not fall at all during the early part of the recession. In general, commercial banks continued to lend and were able to raise capital. Moreover, these banks that were supposedly desperate for capital were paying dividends and bonuses and buying up other banks.
But if the problem is not with commercial banks and if borrowing clearly collapsed, then where did funding stop? "The essence of the financial crisis is that the securitized debt market fell to pieces, not the commercial banks," said Cochrane. In fact, the issuance of mortgage-backed securities and asset-backed commercial paper fell dramatically in recent years. Investors lost appetite for securitized debt, which banks typically rely on to sell their loans.
If Cochrane's story is correct, then the focus of regulatory attention should not have been on saving commercial banks, which is what precisely happened under the recent Troubled Asset Relief Program, or TARP.
Cochrane thinks that what was crucial to the financial crisis was the run on the shadow banking system, which included such dealer banks as Lehman Brothers and Bear Stearns, both of which went bankrupt. These banks were susceptible to runs because they were allowed to use clients' stocks as collateral for their own trading operations, which means that at the first sign of trouble, clients have an incentive to pull out their stocks before others do to make sure that they get their money back. In turn, the resulting "flight to quality" and generic rise in risk premium were central reasons the crisis spread. Cochrane noted that many asset prices collapsed, even in assets that are held directly by consumers such as stocks, bonds, and municipal bonds.
— Vanessa Sumo