Most American adults easily recognize the following description of the 2008 financial crisis. Unregulated shadow banks on Wall Street made excessively risky bets with derivatives, and then the housing bubble burst. Panic ensued, and it nearly destroyed the financial system, but the federal government stepped in and prevented another Great Depression. The traditional banking sector, on the other hand, was highly regulated and, therefore, unable to take so many risky bets. The way to guard against future crises, therefore, is to regulate shadow banks more like commercial banks, and to federally back their securities as if they were retail bank deposits.
This story has many variations, often including Lehman Brothers’ bankruptcy and the run on the Reserve Primary Fund (a large money market mutual fund), but its core remains the conventional view of the 2008 crisis in most academic and policy circles, especially in Washington, D.C. Countless government officials used this story to justify both their actions during the crisis and the major regulatory changes they implemented after the crisis. Now, Biden administration officials are using this story to promote more regulations for money market mutual funds (MMFs), a key part of the supposedly dangerous shadow banking system, and even to justify allowing only federally insured banks to issue stablecoins, a type of cryptocurrency that did not exist during 2008.
Yet, the record demonstrates that the core of this story–unregulated shadow banks, rather than highly regulated traditional banks, nearly caused another Great Depression because they made so many risky bets unbeknownst to federal regulators–is at best highly misleading. In fact, bank regulators blessed much of the so-called shadow banking activity because it took place in the traditional banking sector. Moreover, while supporters of the conventional story liken the 2008 runs on shadow banks to the indiscriminate bank depositor runs experienced in the United States prior to federal deposit insurance, the evidence for such random behavior is surprisingly scarce. Moreover, most of the evidence suggests that, instead of contagion, investors made carefully targeted moves to improve their positions, often due to regulatory or legal requirements.
There is good reason, for instance, to doubt that contagion (indiscriminate panic) caused the run on the Reserve Primary Fund to spread to the rest of the MMF sector, or that it caused turmoil to spread from MMFs to the rest of short-term credit markets. There is even good reason to doubt that federal involvement in credit markets stopped the 2008 crisis, or that strictly regulating more financial firms would result in greater financial stability. This paper provides a comprehensive account of the conventional 2008 crisis story and demonstrates that it does not provide a solid foundation for spreading more bank-like regulations to the rest of financial markets.
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