We teach the Great Depression as history. We teach that after so many American banks went bankrupt in the 1930s, the government instituted proper regulation so that banks would never be able to fail and confidence will always be maintained in the banking system.
For a long time, this notion of banking infallibility was well ingrained in the national psyche. It was just taken for granted that banks made huge profits, and were immune from collapse.
However, with the collapse of Lehman Brothers, even leading economists, are warning of a very real possibility of a financial collapse, not seen since the 1930s.
Lehman Brothers is not a traditional deposit style bank. It is an investment bank which got involved in bundling loans from banks and selling them on through the banking system. They also got heavily involved in the fast growing derivatives market. It was once thought that this 'shadow banking system' would help reduce risk within the banking system. Alas, the reality seems to be it just created a black hole for risk to be completely ignored.
Despite slipping into Rumsfeld speak, (...And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs...) Paul Krugman does a good job in explaining why the collapse of Lehman brothers highlights the growing uncertainty around the financial system.
A year ago, Northern Rock had queues of nervous savers coming to take out their life savings. However, most of the modern-day bank runs occur when nervous investors try to unwind their positions. What this means is that they want to withdraw their loans to other banks, as they are nervous of losing the money. The consequence is that there has been a shortage of liquidity in the financial system, exacerbating the problem of loan defaults by consumers.
Yesterday, the Bank of England and Federal Reserve were forced to inject money into the system. The Bank of England injected £28bn, but, this was still not enough to prevent the LIBOR (interbank lending rate increase by 0.5%.
Recession and Banking Collapse
The last thing the banking system wants is a global slowdown. But, that is precisely what is likely to happen. As the US and Euro economy slips into negative growth, unemployment will rise causing home repossessions to rise even further. This will lead to further bad debts for banks; it could be the straw which brakes the camel's back.
House Prices and Financial System
American house prices have been falling for over 2 years. But, the concern is that European, Australian and other countries house prices could follow suit. Certainly, house prices in Ireland and Spain are overvalued; these could fall significantly leading to more negative equity for the banking system to cope with. It is true, European lenders are not exposed to the same subprime mess as in America; but, falling house prices will hardly help the situation.
Financial System and Confidence
We cannot underestimate the importance of confidence in the financial system. If people don't know whether banks will survive, investors will be too nervous to lend money. Therefore, we will get a further contraction of interbank lending, exacerbating any underlying problem of poor balance sheets.