NEW YORK (MNI) – The following is Federal Reserve Chairman Ben
Bernanke’s remarks titled “Rethinking Finance: Perspectives on the
Crisis” prepared for the Russell Sage Foundation and The Century
Foundation:
I would like to thank the conference organizers for the opportunity
to offer a few remarks on the causes of the 2007-09 financial crisis as
well as on the Federal Reserve’s policy response. The topic is a large
one, and today I will be able only to lay out some basic themes. In
doing so, I will draw from talks and testimonies that I gave during the
crisis and its aftermath, particularly my testimony to the Financial
Crisis Inquiry Commission in September 2010.1 Given the time available,
I will focus narrowly on the financial crisis and the Federal Reserve’s
response in its capacity as liquidity provider of last resort, leaving
discussions of monetary policy and the aftermath of the crisis to
another occasion.
Triggers and Vulnerabilities
In its analysis of the crisis, my testimony before the Financial
Crisis Inquiry Commission drew the distinction between triggers and
vulnerabilities. The triggers of the crisis were the particular events
or factors that touched off the events of 2007-09–the proximate causes,
if you will. Developments in the market for subprime mortgages were a
prominent example of a trigger of the crisis. In contrast, the
vulnerabilities were the structural, and more fundamental, weaknesses in
the financial system and in regulation and supervision that served to
propagate and amplify the initial shocks. In the private sector, some
key vulnerabilities included high levels of leverage; excessive
dependence on unstable short-term funding; deficiencies in risk
management in major financial firms; and the use of exotic and
nontransparent financial instruments that obscured concentrations of
risk. In the public sector, my list of vulnerabilities would include
gaps in the regulatory structure that allowed systemically important
firms and markets to escape comprehensive supervision; failures of
supervisors to effectively apply some existing authorities; and
insufficient attention to threats to the stability of the system as a
whole (that is, the lack of a macroprudential focus in regulation and
supervision).
The distinction between triggers and vulnerabilities is helpful in
that it allows us to better understand why the factors that are often
cited as touching off the crisis seem disproportionate to the magnitude
of the financial and economic reaction. Consider subprime mortgages, on
which many popular accounts of the crisis focus. Contemporaneous data
indicated that the total quantity of subprime mortgages outstanding in
2007 was well less than $1 trillion; some more-recent accounts place the
figure somewhat higher. In absolute terms, of course, the potential for
losses on these loans was large–on the order of hundreds of billions of
dollars. However, judged in relation to the size of global financial
markets, aggregate exposures to subprime mortgages were quite modest. By
way of comparison, it is not especially uncommon for one day’s paper
losses in global stock markets to exceed the losses on subprime
mortgages suffered during the entire crisis, without obvious ill effect
on market functioning or on the economy. Thus, losses on subprime
mortgages can plausibly account for the massive reaction seen during the
crisis only insofar as they interacted with other factors–more
fundamental vulnerabilities–that served to amplify their effects.
On the surface, the puzzle of disproportionate cause and effect
seems somewhat less stark if one takes the boom and bust in the U.S.
housing market as the trigger of the crisis, as the paper gains and
losses associated with the swing in house prices were many times the
losses associated directly with subprime loans. Indeed, the 30 percent
or so aggregate decline in house prices since their peak has by now
eliminated nearly $7 trillion in paper wealth. However, on closer
examination, it is not clear that even the large movements in house
prices, in the absence of the underlying weaknesses in our financial
system, can account for the magnitude of the crisis. First, much of the
decline in house prices has occurred since the most intense phase of the
crisis; the decline in prices since September 2008 is probably better
viewed as largely the result of, rather than a cause of, the crisis and
ensuing recession. More fundamentally, however, any theory of the crisis
that ties its magnitude to the size of the housing bust must also
explain why the fall of dot-com stock prices just a few years earlier,
which destroyed as much or more paper wealth–more than $8
trillion–resulted in a relatively short and mild recession and no major
financial instability.2 Once again, the explanation of the differences
between the two episodes must be that the problems in housing and
mortgage markets interacted with deeper vulnerabilities in the financial
system in ways that the dot-com bust did not. So let me turn, then, to a
discussion of those vulnerabilities and how they amplified the effects
of triggers like the collapse of the subprime mortgage market.
A number of the vulnerabilities I listed a few moments ago were
associated with the increased importance of the so-called shadow banking
system. Shadow banking, as usually defined, comprises a diverse set of
institutions and markets that, collectively, carry out traditional
banking functions–but do so outside, or in ways only loosely linked to,
the traditional system of regulated depository institutions. Examples of
important components of the shadow banking system include securitization
vehicles, asset-backed commercial paper (ABCP) conduits, money market
mutual funds, markets for repurchase agreements (repos), investment
banks, and mortgage companies. Before the crisis, the shadow banking
system had come to play a major role in global finance.
Economically speaking, as I noted, shadow banking bears strong
functional similarities to the traditional banking sector. Like
traditional banking, the shadow banking sector facilitates maturity
transformation (that is, it is used to fund longer-term, less-liquid
assets with short-term, more-liquid liabilities), and it channels
savings into specific investments, mostly debt-like instruments. In
part, the rapid growth of shadow banking reflected various types of
regulatory arbitrage–for example, the minimization of capital
requirements. However, instruments that fund the shadow banking system,
such as money market mutual funds and repos, also met a rapidly growing
demand among investors, generally large institutions and corporations,
seeking cash-like assets for use in managing their liquidity. Commercial
banks were limited in their ability to meet this growing demand by
prohibitions on the payment of interest on business checking accounts
and by relatively low limits on the size of deposit accounts that can be
insured by the Federal Deposit Insurance Corporation (FDIC).
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