The Chairman of the Federal Reserve, Ben Bernanke, spoke at the Russell Sage Foundation and The Century Foundation Conference on "Rethinking Finance". The following are selected passages from that speech, Some Reflections on the Crisis and the Policy Response:
The Crisis as a Classic Financial Panic:
Some Reflections on the Crisis and the Policy Response:...I can briefly sketch the evolution of the crisis itself. As I have noted, developments in housing and mortgage markets played an important role as triggers. Beginning in 2007, declining house prices and rising rates of foreclosure raised serious concerns about the values of mortgage-related assets and considerable uncertainty about where those losses would fall. The economy officially fell into recession in December 2007, following several months of financial stress. However, the most severe economic consequences followed the extreme market movements in the fall of 2008.
To a significant extent, the crisis is best understood as a classic financial panic--differing in details but fundamentally similar to the panics described by Bagehot and many others. The most familiar type of panic that has occurred historically, involving runs on banks by retail depositors, had been made largely obsolete by deposit insurance, central bank backstop liquidity facilities, and the associated government supervision of banks. But a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities and in which providers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence. The combination of dependence on wholesale, short-term financing; excessive leverage; generally poor risk management; and the gaps and weaknesses in regulatory oversight created an environment in which a powerful, self-reinforcing panic could begin.
Indeed, panic-like phenomena arose in multiple contexts and in multiple ways during the crisis. The repo market, a major source of short-term credit for many financial institutions, notably including the independent investment banks, was an important example. In repo agreements, loans are collateralized by financial assets, and the maximum amount of the loan is the current assessed value of the collateral less a safety margin, or haircut. The secured nature of repo agreements gave firms and regulators confidence that runs were unlikely. But this confidence was misplaced. Once the crisis began, repo lenders became increasingly concerned about the possibility that they would be forced to receive collateral instead of cash, collateral that would then have to be disposed of in falling and illiquid markets. In some contexts, lenders responded by imposing increasingly higher haircuts, cutting the effective amount of funding available to borrowers. In other contexts, lenders simply pulled away, as in a deposit run; in these cases, some borrowers lost access to repo entirely, and some securities became unfundable in the repo market. In either case, absent sufficient funding, borrowers were frequently left with no option but to sell assets into illiquid markets. These forced sales drove down asset prices, increased volatility, and weakened the financial positions of all holders of similar assets. Volatile asset prices and weaker borrower balance sheets in turn heightened the risks borne by repo lenders, further boosting the incentives to demand higher haircuts or withdraw funding entirely. This unstable dynamic was operating in full force around the time of the near failure of Bear Stearns in March 2008, and again during the worsening of the crisis in mid-September of that year.
Classic panic-type phenomena occurred in other contexts as well. Early in the crisis, structured investment vehicles and many other asset-backed programs were unable to roll over their commercial paper as investors pulled back, and the programs were forced to draw on liquidity lines from banks or to sell assets. The resulting pressure on the bank liquidity providers, evident especially in the market for dollar-denominated loans in short-term funding markets, impeded the functioning of the financial system throughout the crisis. Following the Lehman collapse and the "breaking of the buck" by a money market mutual fund that held commercial paper issued by Lehman, both money market mutual funds and the commercial paper market were also subject to runs. More generally, during the crisis, runs of short-term uninsured creditors created severe funding problems for a number of financial firms, including several large broker-dealers and also some bank holding companies. In some cases, withdrawals of funds by creditors were augmented by "runs" in other guises--for example, by prime brokerage customers of investment banks concerned about the safety of cash and securities held at those firms or by derivatives counterparties demanding additional margin. Overall, the emergence of run-like phenomena in a variety of contexts helps explain the remarkably sharp and sudden intensification of the financial crisis, its rapid global spread, and the fact that standard market indicators largely failed to forecast the abrupt deterioration in financial conditions.
The multiple instances of run-like behavior during the crisis, together with the associated sharp increases in liquidity premiums and dysfunction in many markets, motivated much of the Federal Reserve's policy response. Bagehot advised central banks--the only institutions that have the power to increase the aggregate liquidity in the system--to respond to panics by lending freely against sound collateral. Following that advice, from the beginning of the crisis, the Fed, like other major central banks, provided large amounts of short-term liquidity to financial institutions, including primary dealers as well as banks, on a broad range of collateral. Reflecting the contemporary institutional environment, it also provided backstop liquidity support for components of the shadow banking system, including money market mutual funds, the commercial paper market, and the asset-backed securities markets. To be sure, the provision of liquidity alone can by no means solve the problems of credit risk and credit losses, but it can reduce liquidity premiums, help restore the confidence of investors, and thus promote stability. It can also reduce panic-driven credit problems in cases in which such problems result from price declines during liquidity-driven fire sales of assets.
The pricing of the liquidity facilities was an important part of the Federal Reserve's strategy. Rates could not be too high; to have a positive effect, and to minimize the stigma of borrowing, the facilities had to be attractive relative to rates available (or nominally available) in illiquid, dysfunctional markets. At the same time, pricing had to be sufficiently unattractive that borrowers would voluntarily withdraw from these facilities as market conditions normalized. This desired outcome in fact occurred: By early 2010, emergency lending had been drastically reduced, along with the demand for such lending.
The Federal Reserve's responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis--a framework that we now have. However, those actions were, again, consistent with the Bagehot approach of lending against collateral to illiquid but solvent firms. The acquisition of Bear Stearns by JPMorgan Chase was facilitated by a Federal Reserve loan against a designated set of assets, and the provision of liquidity to AIG was collateralized by the assets of the largest insurance company in the United States. In both cases the Federal Reserve determined that the loans were adequately secured, and in both cases the Federal Reserve has either been repaid with interest or holds assets whose assessed values comfortably cover remaining loans.
To say that the crisis was purely a liquidity-based panic would be to overstate the case. Certainly, an important part of the resolution of the crisis involved assuring markets and counterparties of the solvency of key financial institutions, and that assurance was provided in significant part by the injection of capital, including public capital, and the issuance of guarantees--measures not available to the Federal Reserve. In these respects, the Treasury-managed Troubled Asset Relief Program and the FDIC's Temporary Liquidity Guarantee Program played critical roles. As I have noted, the Federal Reserve did help restore confidence in the solvency of the banking system by leading the stress tests of the 19 largest U.S. bank holding companies in the spring of 2009. These stress tests, which were both rigorous and transparent, helped make it possible for the tested banks to raise $120 billion in private capital in the ensuing months.
The response to the panic also involved an extraordinary amount of international consultation and coordination. Following a key meeting of the Group of Seven finance ministers and central bank governors in Washington on October 10, 2008, the governments of other industrial countries took strong measures to stabilize key financial institutions and markets. Central banks collaborated closely throughout the crisis; in particular, the Federal Reserve undertook swap agreements with 14 other central banks to help ensure adequate dollar liquidity in global markets and thus keep credit flowing to U.S. households and businesses...[Continue]