A Template for Understanding Big Debt Crises

by Ray Dalio

The banks’ (and investment banks’) balance sheet and liquidity problems were on both the asset side and the liability side. On the asset side, the problems stemmed from the banks’ ownership of subprime mortgages through securitizations. On the liability side, the banks had become dependent on risky sources of funding. Banks had always relied on short-term funding, but historically this had consisted largely of deposits, which could be controlled with guarantees. Savers can always pull their deposits, and widespread fears about bank solvency had led them to do just that in the Great Depression. This led to the founding of the FDIC in 1933, which dealt with this problem by insuring bank deposits (up to a certain amount). That mostly eliminated the incentives the depositors had to flee, because even if a bank failed, their deposits would be protected.