WASHINGTON (MNI) – The following is the second of five sections of
the text of Federal Reserve Chairman Ben Bernanke’s remarks prepared for
the Bendheim Center for Finance and the Center for Economic Policy
Studies at Princeton University Friday afternoon:

How Economics Helped Us Understand and Respond to the Crisis

The financial crisis represented an enormously complex set of
interactions–indeed, a discussion of the triggers that touched off the
crisis and the vulnerabilities in the financial system and in financial
regulation that allowed the crisis to have such devastating effects
could more than fill my time this afternoon.1

(1 For a more comprehensive discussion of vulnerabilities and
triggers during the financial crisis, see Ben S. Bernanke (2010),
“Causes of the Recent Financial and Economic Crisis,” testimony before
the Financial Crisis Inquiry Commission, September 2,
www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm.)

The complexity of our financial system, and the resulting
difficulty of predicting how developments in one financial market or
institution may affect the system as a whole, presented formidable
challenges. But, at least in retrospect, economic principles and
research were quite useful for understanding key aspects of the crisis
and for designing appropriate policy responses.

For example, the excessive dependence of some financial firms on
unstable short-term funding led to runs on key institutions, with highly
adverse implications for the functioning of the system as a whole. The
fact that dependence on unstable short-term funding could lead to runs
is hardly news to economists; it has been a central issue in monetary
economics since Henry Thornton and Walter Bagehot wrote about the
question in the 19th century.2

(2 See Henry Thornton ([1802] 1962), An Enquiry into the Nature and
Effects of the Paper Credit of Great Britain (New York: A. M. Kelley);
and Walter Bagehot ([1873] 1897), Lombard Street: A Description of the
Money Market (New York: Charles Scribners Sons). A discussion relating
the Federal Reserve’s policy actions during the financial crisis to the
ideas of Bagehot is contained in Brian F. Madigan (2009), “Bagehots
Dictum in Practice: Formulating and Implementing Policies to Combat the
Financial Crisis,” speech delivered at “Financial Stability and
Macroeconomic Policy,” a symposium sponsored by the Federal Reserve Bank
of Kansas City, held in Jackson Hole, Wyo., August 20-22, available at
www.federalreserve.gov/newsevents/speech/madigan20090821a.htm. See also
Ben S. Bernanke (2008), “Liquidity Provision by the Federal Reserve,”
speech delivered at the Federal Reserve Bank of Atlanta Financial
Markets Conference (via satellite), held in Sea Island, Ga., May 13,
www.federalreserve.gov/newsevents/speech/bernanke20080513.htm.)

Indeed, the recent crisis bore a striking resemblance to the bank
runs that figured so prominently in Thorntons and Bagehots eras; but
in this case, the run occurred outside the traditional banking system,
in the shadow banking system–consisting of financial institutions other
than regulated depository institutions, such as securitization vehicles,
money market funds, and investment banks. Prior to the crisis, these
institutions had become increasingly dependent on various forms of
short-term wholesale funding, as had some globally active commercial
banks. Examples of such funding include commercial paper, repurchase
agreements (repos), and securities lending. In the years immediately
before the crisis, some of these forms of funding grew especially
rapidly; for example, repo liabilities of U.S. broker-dealers increased
by a factor of 2-1/2 in the four years before the crisis, and a good
deal of this expansion reportedly funded holdings of relatively less
liquid securities.

In the historically familiar bank run during the era before deposit
insurance, retail depositors who heard rumors about the health of their
bank — whether true or untrue — would line up to withdraw their funds.
If the run continued, then, absent intervention by the central bank or
some other provider of liquidity, the bank would run out of the cash
necessary to pay off depositors and then fail as a result. Often, the
panic would spread as other banks with similar characteristics to, or
having a financial relationship with, the one that had failed came under
suspicion. In the recent crisis, money market mutual funds and their
investors, as well as other providers of short-term funding, were the
economic equivalent of early-1930s retail depositors. Shadow banks
relied on these providers to fund longer-term credit instruments,
including securities backed by subprime mortgages. After house prices
began to decline, concerns began to build about the quality of subprime
mortgage loans and, consequently, about the quality of the securities
into which these and other forms of credit had been packaged. Although
many shadow banks had limited exposure to subprime loans and other
questionable credits, the complexity of the securities involved and the
opaqueness of many of the financial arrangements made it difficult for
investors to distinguish relative risks. In an environment of heightened
uncertainty, many investors concluded that simply withdrawing funds was
the easier and more prudent alternative. In turn, financial
institutions, knowing the risks posed by a run, began to hoard cash,
which dried up liquidity and significantly limited their willingness to
extend new credit.3

(3 See Gary B. Gorton (2008), ‘The Panic of 2007,’ paper presented
at ‘Maintaining Stability in a Changing Financial System,’ a symposium
sponsored by the Federal Reserve Bank of Kansas City, held in Jackson
Jackson Hole, Wyo., August 21-23; the paper is available at
www.kansascityfed.org/publications/research/escp/escp-2008.cfm. Also see
Markus K. Brunnermeier (2009), ‘Deciphering the Liquidity and Credit
Crunch 2007-2008,’ Journal of Economic Perspectives, vol. 23 (Winter),
pp. 77-100.)

Because the runs on the shadow banking system occurred in a
historically unfamiliar context, outside the commercial banking system,
both the private sector and the regulators insufficiently anticipated
the risk that such runs might occur. However, once the threat became
apparent, two centuries of economic thinking on runs and panics were
available to inform the diagnosis and the policy response. In
particular, in the recent episode, central banks around the world
followed the dictum set forth by Bagehot in 1873: To avert or contain
panics, central banks should lend freely to solvent institutions,
against good collateral.4

The Federal Reserve indeed acted quickly to provide liquidity to
the banking system, for example, by easing lending terms at the discount
window and establishing regular auctions in which banks could bid for
term central bank credit. Invoking emergency powers not used since the
1930s, the Federal Reserve also found ways to provide liquidity to
critical parts of the shadow banking system, including securities
dealers, the commercial paper market, money market mutual funds, and the
asset-backed securities market. For todays purposes, my point is not to
review this history but instead to point out that, in its policy
response, the Fed was relying on well-developed economic ideas that have
deep historical roots.

(4 Bagehot also suggested that “these loans should only be made at
a very high rate of interest” (Lombard Street, p. 99; see note 2. Some
modern commentators have rationalized Bagehots dictum to lend at a high
or “penalty” rate as a way to mitigate moral hazard — that is, to help
maintain incentives for private-sector banks to provide for adequate
liquidity in advance of any crisis. However, the risk of moral hazard
did not appear to be Bagehot’s principal motivation for recommending a
high rate; rather, he saw it as a tool to dissuade unnecessary borrowing
and thus help protect the Bank of Englands own finite store of liquid
assets. See Bernanke, “Liquidity Provision,” in note 2 for further
documentation. Today, potential limitations on the central banks
lending capacity are not nearly so pressing an issue as in Bagehots
time, when the central bank’s ability to provide liquidity was far more
tenuous. Generally, the Federal Reserve lent at rates above the normal
rate for the market but lower than the rate prevailing in distressed and
illiquid markets. This strategy provided needed liquidity while
encouraging borrowers to return to private markets when conditions
normalized.)

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** Market News International Washington Bureau: 202-371-2121 **

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