A Broad View of What Constitutes a Bank

In today’s column Paul Krugman (“It’s a Miserable Life,” The New York Times, 20 August 2007) points out an interesting aspect 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.

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.

Mr. Krugman points out that while the banking industry narrowly defined is well regulated — that is, both brought under law and made more uniform and predictable — by a host of institutions — the FDIC, the Federal Reserve, various banking laws, the Basil accords, et cetera — these other bank-like institutions are not similarly covered. Hence, the Fed can modify its rates all it wants and the FDIC may offer insurance, but these don’t effect the pricing of asset backed securities or the willingness of investors to purchase commercial paper in anything like the way that they effect regular banking.

Just as the financial sector innovates, so regulation and governing institutions should innovate as well. Unfortunately the sort of consensus that produces institutions like the Federal Reserve or the FDIC come only out of major crises — not the sort at which we are currently looking. For that, the financial system will have to build up a lot more pressure.