Ask most Americans what a bank run looks like and they'll probably describe the scene from It's a Wonderful Life, where depositors show up en masse at Bailey Savings & Loan, forcing Jimmy Stewart to explain why he doesn't have the cash to meet all withdrawal requests.
That was what a bank run looked like in 1930. But thanks to the creation of the Federal Deposit Insurance Corp. and insurance to protect bank depositors, that wasn't what a bank run looked like in 2008 and or what it might look like if financial markets lose faith in Washington's ability to defuse the current debt-limit crisis.
Even though it was the failure of the Wall Street firm Lehman Brothers that grabbed headlines in 2008, it was a panic in the so-called repo market that almost brought the financial system to its knees. Formally known as repurchase agreements, repos allow banks and other financial institutions to post Treasury bills, commercial paper, and other short-term instruments as collateral for ultra-low interest-rate loans. Such loans last for one day but can be rolled over. Lenders who want their cash back merely decline to renew.
In the shadows
Repo market players include banks regulated by the FDIC, and primary dealers who purchase securities directly from the Federal Reserve. But the market also includes money-market mutual funds, hedge funds, private-equity funds, and others that make up what's known as the shadow banking system.
After Lehman failed in 2008, this shadow banking system suffered a run, which peaked on Sept. 16 when a giant money-market fund was forced to mark down the net asset value of its shares below $1—"breaking the buck" in Wall Street parlance. The move profoundly shook the markets, and prompted the U.S. Treasury to step in and temporarily insure money-market fund investors against further principal losses.
The repo market survived and today is worth some $5 trillion. Primary dealers in government debt depend on it to turn their inventories into cash. But the market is again showing signs of stress. Some money-market funds have told repo partners they won't accept Treasury bills maturing in October and November as collateral. They're taking that precaution because of the risk that Congress won't resolve its impasse over the U.S. debt ceiling in time, leaving the government short of cash to meet obligations.
SEC proposals on hold
What makes this situation more troubling is that reforms proposed by the Securities and Exchange Commission to avoid another money-market mutual fund crisis have yet to be approved. Policymakers still haven't agreed on the best way to prevent runs on the shadow banking system.
The SEC has proposed allowing money-market share values to float instead of maintaining net-asset values at $1, and also suggested funds impose withdrawal fees on investors to deter future runs. Boston Fed President Eric Rosengren, in whose district many money-market mutual funds are based, favors eliminating the $1 NAV requirement, but thinks that withdrawal fees and other obstacles to redemption could actually increase the risk of runs.
Other regulators, meanwhile, have been trying to reduce risk in the repo market by weaning primary dealers from their dependence on intraday credit. On Oct. 4, New York Fed President William Dudley told a conference that the percentage of tri-party repo activity being financed on an intraday basis has declined from 100% in 2008 to 70% currently, and that it will fall below 10% by the end of 2014.
Asset fire sales still a risk
Dudley is particularly focused on the tri-party market, where post-trade processing, including the selection of collateral, payment, and settlement as well as custody and management during the life of the repo is outsourced by the counterparties to an agent. In the U.S., third-party repos account for two-thirds of all repos, vs. 10% to 12% in the European market, according to the industry's self-regulatory body, the International Capital Market Association.
Much remains to be done. Beefed-up risk management practices and turbocharged technology still don't address the risk of asset fire sales in the event of a crisis. Dudley has called it essential to fix problems while markets are "functioning without stress," especially since the Dodd-Frank reform raised the bar for Fed intervention, by blocking the central bank from bailing out a single financial institution at its own discretion.
With the possibility of a new U.S. debt crisis as soon as this month, that window for reform may have already closed.
Monica Gagnier is a Economics Writer at Moody's Analytics.
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