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Paul Krugman: Financial Russian Roulette - SPIEGEL ONLINE - News - International

If institutions need to be rescued like banks, they should be regulated like banks -- why were we so unprepared for this latest shock?

 Can the Fed do anything to stop the continuing series of collapses of major financial institutions? Will the US financial system collapse today, or maybe over the next few days? I don't think so -- but I'm nowhere near certain. You see, Lehman Brothers, a major investment bank, is apparently about to go under. And nobody knows what will happen next.

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the "shadow banking system." Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by "nondepository" institutions, institutions like the late lamented Bear Stearns -- and Lehman.

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn't so much reduced as hidden: all too many investors had no idea how exposed they were.

by Fran on Mon Sep 15th, 2008 at 06:18:22 AM EST

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