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Banks and Non-Banks: Project Syndicate for September 2007

Axel Weber of the Bundesbank Picks Up on Paul Krugman's "Non-Bank Bank Run"

Paul Kedrosky reports:

Paul Kedrosky: The First Non-Bank Bank Run: In a speech at the Jackson Hole economic conference this weekend, Bundesbank president Axel Weber did a nice put of putting into words what is really going in financial markets. Call it the first "non-bank bank run".

The current turmoil in the financial markets has all the characteristics of a classic banking crisis, but one that is taking place outside the traditional banking sector.... Mr Weber told fellow central bankers and economists at the Federal Reserve’s Jackson Hole symposium that the only difference between a classic banking crisis and the turmoil under way in the markets is that the institutions most affected at the moment are conduits and investment vehicles raising funds in the commercial bond market, rather than regulated banks. These entities were inherently vulnerable to a sudden loss of confidence on the part of their funders because “there is a maturity mismatch” on the part of financial institutions that have invested in long term mortgage-backed or asset-backed securities using short-term finance.

The ever-quotable Paul McCulley of Pimco went on to call it a "run on the shadow banking system".

As Paul Krugman put it two weeks ago:

It’s a Miserable Life - New York Times: Old-fashioned bank runs just don’t make sense these days. New-fashioned bank runs, on the other hand, do make sense — and they’re at the heart of the current financial crisis. The key to understanding what’s happening is taking a broad view of what constitutes a bank. From an economic perspective, a bank is any institution that offers people liquidity — the ability to convert their assets into cash on short notice — while still using their money to make long-term investments.

Traditional banks promise depositors the right to withdraw their funds at any time. Yet banks lend out most of the money depositors place in their care, keeping only a fraction in cash. The reason this works is that normally a bank’s depositors want to withdraw only a small proportion of their money on any given day. Banks get in trouble, however, when some event, like a rumor that major loans have gone bad, leads many depositors to demand their money at the same time. The scary thing about bank runs is that doubts about a bank’s soundness can be a self-fulfilling prophecy.... That’s why bank deposits are now protected by a combination of guarantees and regulation.... But these guarantees and regulations apply only to traditional banks. Meanwhile, a growing number of unregulated bank-like institutions have become vulnerable to the 21st-century version of bank runs.

Consider the case of KKR Financial Holdings, an affiliate of Kohlberg Kravis Roberts, a powerhouse Wall Street operator. KKR Financial raises money by issuing asset-backed commercial paper — a claim that’s sort of like a short-term C.D., used by large investors to temporarily park funds — and invests most of this money in longer-term assets. So the company is acting as a kind of bank, one that offers a higher interest rate than ordinary banks pay their clients. It sounds like a great deal — except that last week KKR Financial announced that it was seeking to delay $5 billion in repayments. That’s the equivalent of a bank closing its doors because it’s running out of cash.

The problems at KKR Financial are part of a broader picture in which many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.

On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick. The problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to depository institutions, a k a old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks...