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Securitization and the rise of market-based banking

Securitization and the eclipse of the post-World War II banking regime

During the three-plus decades of embedded liberalism following World War II, banks were highly regulated, reliably profitable and enjoyed unprecedented stability. Indeed, as Gary Gorton notes, “[t]here was no financial crisis between 1934 and 2007 because [this] Quiet Period was an era in which banks were earning monopoly profits, based on high charter values and a lack of invasive innovation” (Gorton 2012, pg. 133). During this era of 3-6-3 banking, banks “did not want to jeopardize their charters by taking risk, and there was no reason for banks to innovate, because they were profitable” (Gorton 2012, pg. 133).

This quiet period for banking ended as “[t]he traditional model of banking began to break down because of competition from outside the regulated banking sector in the early 1980s” (Gorton 2012, pp. 127, 133). In particular, the compromise underpinning the quiet period - bank charters entitled banks to reliable profits in exchange for heavy regulation, with everyone benefitting from increased financial stability - was undone by the emergence of “shadow banking” institutions selling new financial products, such as money market mutual funds for savers who might have otherwise put their money in traditional savings accounts and junk bonds and asset-backed commercial paper for corporate borrowers who might have otherwise sought a bank loan (Adrian and Ashcraft 2012). As a result, “companies without banking charters [begin to] compete with banks by offering the same services, the value to a bank of having a charter decreases, and to compete and stay afloat, a bank must take on more risk” (Gorton 2012, pg. 125), something that required a change in the basic business model of banking.

For traditional banks facing grave new competitive threats from shadow banking products, ICT-enabled securitization emerged as a way to respond to these challenges. In the run-up to the GFC, the securitization machines developed by banks turned out MBS and other products that were attractive to global investors seeking to find investments for a “giant pool of money” that was growing by trillions of dollars per year.[1] This system was facilitated by the computational power provided by new ICT tools (Zysman et al. 2013, pg. 109) and there remains a consensus even after the GFC that ICT-enabled complexity will be a permanent feature of finance and banking, something that was underscored when Mary Jo White, who was arguably the top regulatory-enforcement lawyer on Wall Street at the time, was nominated to chair the Securities and Exchange Commission and The New York Times stated (somewhat ridiculously) that “she could face questions about her command of Wall Street arcana” (Protess and Weiser 2013).

  • [1] By some estimates, ‘the giant pool of money’ set aside to be invested in fixed-income investments (e.g., ordinary bonds, MBS) grew from $36 trillion in 2000 to $70 trillion in 2008 (ThisAmerican Life 2008).
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