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Systemic Risk Regulation and the 2008 Financial Crisis Myths

Many government papers rehash the same tale of the 2008 financial crisis in order to justify more expansive systemic risk restrictions.

The popular narrative regarding the 2008 financial crisis is that, when the so-called "shadow banks" made too many risky bets, difficulty at one huge money market mutual fund (MMF) sparked a contagious run on other MMFs, which soon spread throughout short term credit markets. According to the account, the contagion was only stopped until the federal government gave widespread financial guarantees.

Countless government officials have used this scenario to defend both their actions during the crisis and the massive regulatory adjustments they adopted following the crisis, including two rounds of MMF rule revisions. The Biden administration is now using the same argument to advocate for further rules on MMFs and to justify limiting the issue of stablecoins to federally insured institutions.

This story is profoundly deceptive, and both the restrictions that have been adopted and those that have been suggested in the name of avoiding future systemic risk events are deeply flawed. In this briefing paper, I highlight the fundamental flaws in the mainstream explanation of the 2008 financial crisis and explain why it does not support imposing bank-like restrictions across financial markets to prevent systemic risks.

Redemptions and Declines Are Not Contagion

Many government papers rehash the same tale of the 2008 financial crisis in order to justify more expansive systemic risk restrictions. For example, in December 2020, the President's Working Group on Financial Markets issued a report on MMF reform possibilities that included the following passage:

In September 2008, there was a run on certain types of MMFs after the failure of Lehman Brothers caused a large prime MMF that held Lehman Brothers short‐​term instruments to sustain losses and “break the buck.” During that time, prime MMFs experienced significant redemptions that contributed to dislocations in short‐​term funding markets, while government MMFs experienced net inflows. Ultimately, the run on prime MMFs abated after announcements of a Treasury guarantee program for MMFs and a Federal Reserve facility designed to provide liquidity to MMFs. Subsequently, the Securities and Exchange Commission (“SEC”) adopted reforms (in 2010 and 2014) that were designed to address the structural vulnerabilities that became apparent in 2008.

The rush to redeem shares or turn an investment into cash is the key feature of what happened, according to proponents of stronger regulation. These runs are the first signs of a spreading panic that has the potential to affect other markets. This point of view is highlighted in a new presidential working group study on stablecoins, which claims:

Runs could spread contagiously from one stablecoin to another, or to other types of financial institutions that are believed to have a similar risk profile. Risks to the broader financial system could rapidly increase as well, especially in the absence of prudential standards.

Despite the numerous accounts that make such claims of contagious runs, there is surprisingly little evidence that they have occurred.

The report on money market funds by the 2020 President's Working Group on Financial Markets, for example, shows no data to support the MMF contagion theory. It does refer readers to a 2010 study for a "more extensive review of the MMF related events in 2008,"4 but that older paper similarly makes claims without presenting evidence of MMF contagion in 2008. 5 The 2010 paper accurately describes the billions of dollars that flowed out of key institutional MMFs during the 2008 crisis, but these outflows do not prove MMF contagion.

In reality, some official publications reveal information contradicting the contagion scenario inadvertently. According to a 2012 Financial Stability Oversight Council assessment, for example:

Outflows from institutional prime MMFs following the Lehman bankruptcy tended to be larger among MMFs with sponsors that were themselves under stress, indicating that MMF investors redeemed shares when concerned about sponsors’ potential inabilities to bolster ailing funds. These run dynamics were primarily prevalent among the more sophisticated, risk‐​averse institutional investors, as institutional funds accounted for 95 percent of the net redemptions from prime funds. [Emphasis added.]

According to the research, "MMFs managed by just a dozen firms accounted for over three quarters of the $202 billion reduction in the industry's holdings" of commercial paper, and "five MMF sponsors accounted for nearly half of the decline." These data, taken together, provide evidence against the contagion story: almost all of the outflows were from wealthy, sophisticated investors, and those investors did not run indiscriminately, as is required for contagion.

Concerning whether MMF share redemptions produced problems in other short term credit markets, various government reports claim that massive MMF withdrawals "frozen" short term credit markets. According to the 2010 working group report, the short term credit markets froze when "MMFs decreased their holdings of commercial paper by around $170 billion (25 percent)" in September 2008. There is little doubt that short term credit markets, like nearly all firms, were stressed during the crisis, but the evidence suggests that short term credit markets did not freeze. In reality, much of the evidence shows that these markets functioned just as they were intended to, allowing even the most riskaverse investors to choose safer options.

According to Federal Reserve figures, total outstanding commercial paper (short term borrowings outside of the banking sector) decreased $207 billion in the second half of September 2008, representing a net decline of 11% of total commercial paper outstanding at the start of the month. Nonetheless, as of October 1, $1.6 trillion in commercial paper remained outstanding. Because of the scale of the market and the short term nature of commercial paper, referring to a $200 billion net decline as a frozen commercial paper market is incorrect. In 2008, like in previous years, 69 percent of outstanding commercial paper matured in one to four days, with 75 percent maturing in fewer than nine days. According to these calculations, at least $800 billion of the outstanding amount was made up of fresh commercial paper issues.

Multiple analyses, in addition to raw data, show that the asset backed commercial paper (ABCP) market, the hardest damaged segment of the commercial paper industry, did not freeze. For example, a study written by Federal Reserve Board experts mentions the collapse of the ABCP market but nonetheless demonstrates that maturities of new issues decreased over time. It also claims that "for the programs that could issue, yield spreads and maturities of new issues exhibited explainable variance during the crisis," and that "runs in the crisis were not random, but were much more common at riskier programs." As a result, the evidence indicates that the market did not freeze, and that contagion was not the issue.

Separately, many major MMFs increased their assets around the time of the Lehman bankruptcy and the run on the Reserve Primary Fund. According to an SEC report, "the mean prime money market fund experienced large weekly net redemptions, and many individual funds experienced weekly net redemptions that exceeded 10%; however, many individual prime funds experienced weekly net purchases that exceeded 5 and 10% of fund assets during the Crisis Month [defined as September 2, 2008 to October 7, 2008]." To put it another way, while prime MMFs as a whole lost assets during this period, many individual prime MMFs acquired assets at the same time. Again, this data reveals that the markets did not freeze, and it also contradicts the broad contagion theory.

Revealing the Shadow Banks

Since the 2008 financial crisis, numerous government officials have called for nonbank financial enterprises to be subject to bank-like laws in order to protect against potential systemic risks. They usually defend these efforts by citing the standard tale of the 2008 financial crisis, stating that the problem was a lack of regulation among so-called "shadow banks." Of course, the subtext is that the banking industry is safer because it is so heavily regulated, and that regulators would never have let commercial banks to engage in such dangerous behavior. However, it turns out that the majority of this risky activity was carried out with the explicit approval of federal authorities by highly regulated commercial banks.

In general, banks were principally responsible for the enormous surge in securitization (the issuance of securities whose value is linked to pools of other assets such as mortgages or consumer loans) that began in the late 1980s. According to a Federal Reserve report from 2012, "banks are by far the dominating factor in the securitization market," and banks have been "a significant force in these shadow banking segments related to securitization all along." From 1990 to 2008, commercial banks held a market share of well over 90% for the primary tasks of securitization (including issuing, trustee services, underwriting, and servicing).

For decades, commercial banks have been strongly involved in commercial paper and MMFs. Commercial banks, for example, typically establish separate organizations (conduits) to issue assetbacked commercial paper and provide credit or liquidity guarantees. In other words, the majority of this paper is offered to outside investors with explicit guarantees that obligate commercial banks to pay up maturing ABCP at full face value in the case of default. On the eve of the financial crisis in 2007, 67 of the 127 Moody's Investors Service-rated sponsors were commercial banks, accounting for 74% of the outstanding ABCP ($911 billion). Furthermore, the majority of the issuance was concentrated in the largest institutions—the top ten commercial bank sponsors accounted for 37% of total ABCP outstanding.

A growing number of commercial banks have even sponsored money market mutual funds since the 1980s. Banksponsored prime institutional MMFs, for example, went from "a minuscule percentage of the market in 1986" to over half ($227 billion) of all prime institutional MMF assets by the year 2000, and to 52% ($612 billion) by the end of 2007. Banks, like commercial paper, provide explicit guarantees for their conduits that produce MMFs, increasing the commercial banking sector's obligations.

While the repurchase agreement (repo) market does not primarily rely on asset backed securities for collateral, it is closely linked to the banking industry. By far the most widely utilized collateral in the repo market is U.S. Treasury securities, with agency debt and mortgage backed securities a close second, accounting for nearly 70% of the collateral used in the repo market. Securities dealers have historically been the top borrowers in the repo markets (with an average share of more than 53% of all borrowings over the last two decades), as well as the largest investors in the repo market (accounting for 40 percent of the total share for the last 20 years).

The triparty repo market is a large component of the repo market that relies on two clearing institutions (the Bank of New York Mellon and J. P. Morgan Chase) to provide settlement and collateral management services. The majority of MMF repos are completed in the triparty segment, and the majority of their funds are invested in repos with the same financial institutions that serve as the Federal Reserve's principal dealers. Money market mutual funds accounted for 22% of all repo loans in 2020, yet they do not borrow in the repo market.

Clearly, referring to these actions as part of a shadow banking sector is deceptive. None of this occurred in the shadows, and almost all of it occurred either directly through a commercial bank or through an affiliate of a Fedregulated bank holding company. It happened without a doubt with the express approval of banking regulators. Aside from the numerous legislative changes that enabled banks to engage in these actions, all bank activities are subject to rigorous monitoring by federal authorities. It is impossible to deny that the federal government's attempts to stabilize financial markets in 2008 were primarily geared at strengthening the banking sector.

Banking Regs Have Not Produced Stability

Over the last century, federal bank regulations have become increasingly prescriptive, and many government officials now seek to extend that regulatory framework to the nonbank part of financial markets. However, there is cause to wonder that these stronger bank restrictions benefited the financial sector, even on a worldwide scale. Professors Charles Calomiris and Stephen Haber emphasize in the prologue to their 2014 book, Fragile by Design, that it was published "after the worst three decades of banking crises the world has ever seen."

There is no question that the federal capital framework played a role in the accumulation of all sorts of mortgage backed securities (MBS) in the banking sector prior to the 2008 crisis, and that regulators explicitly established that framework to create a safe banking system. In 2001, federal regulators enacted the recourse rule, which gave certain AA- and AAA-rated asset-backed securities the same low risk weight as agency-issued MBS, prompting the ten largest American banks to increase their purchases of private label MBS and collateralized debt obligation bonds. Given that current banking regulation has such a terrible overall track record of achieving financial stability, it is difficult to understand how imposing additional banklike requirements on capital market enterprises could accomplish financial stability.


Numerous government officials cite the conventional account about the 2008 financial crisis to defend their actions during the crisis as well as the substantial regulatory measures adopted following the crisis. Now, the Biden administration is using the same example to advocate for stricter controls on money market mutual funds and to justify stricter regulations on stablecoins. The mainstream narrative of the 2008 financial crisis does not hold up under investigation, and using it to justify laws to prevent future systemic risks is highly erroneous.

However, much of the evidence shows that nonbank financial markets functioned just as they were intended to. The historical record also shows that commercial banks were extensively involved in the majority of so-called shadow banking activity at the heart of the 2008 financial crisis. This fact not only implies that the federal government's efforts in 2008 were targeted at preserving the banking industry, but it also demonstrates that federal authorities explicitly approved of these so-called shadow banking activities as safe.

The research implies that if banks were not subject to such a comprehensive topdown regulatory framework, the banking sector would be more stable. Today's too prescriptive regime has unmistakably generated volatility in the banking, nonbanking, and broader economies. It makes no sense to broaden it. Government officials must admit that they cannot build vibrant capital markets that are always absolutely stable if they also wish to allow investors to take the risks that produce vibrant capital markets.

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