NEW YORK (MNI) – The following is the second of seven sections of
Federal Reserve Chairman Ben Bernanke’s remarks titled “Rethinking
Finance: Perspectives on the Crisis” prepared for the Russell Sage
Foundation and The Century Foundation:
As became apparent during the crisis, a key vulnerability of the
system was the heavy reliance of the shadow banking sector, as well as
some of the largest global banks, on various forms of short-term
wholesale funding, including commercial paper, repos, securities lending
transactions, and interbank loans. The ease, flexibility, and low
perceived cost of short-term funding also supported a broader trend
toward higher leverage and greater maturity mismatch in individual
shadow banking institutions and in the sector as a whole.
While banks also rely on short-term funding and leverage, they
benefit from a government-provided safety net, including deposit
insurance and backstop liquidity provision by the central bank. Shadow
banking activities do not have these safeguards, so they employ
alternative mechanisms to gain investor confidence. Among these
mechanisms are the collateralization of many shadow banking liabilities;
regulatory or contractual restrictions placed on portfolio holdings,
such as the liquidity and credit quality requirements applicable to
money market mutual funds; and the imprimaturs of credit rating
agencies. Indeed, the very foundation of shadow banking and its rapid
growth before the crisis was the widely held view (among both investors
and regulators) that these safeguards would protect shadow banking
activities against runs and panics, similar to the protection given to
commercial banking by the government safety net. Unfortunately, this
view turned out to be wrong. When it became clear to investors that
these alternative protections might not be adequate to protect against
losses, widespread flight from the shadow banking system occurred, with
pernicious dynamics reminiscent of the banking panics of an earlier era.
Although the vulnerabilities associated with short-term wholesale
funding and excessive leverage can be seen as structural weaknesses of
the global financial system, they can also be viewed as a consequence of
poor risk management by financial institutions and investors, which I
would count as another major vulnerability of the system before the
crisis. Unfortunately, the crisis revealed a number of significant
defects in private-sector risk management and risk controls, importantly
including insufficient capacity by many large firms to track firmwide
risk exposures, such as off-balance-sheet exposures.
This lack of capacity by major financial institutions to track
firmwide risk exposures led in turn to inadequate risk diversification,
so that losses–rather than being dispersed broadly–proved in some
cases to be heavily concentrated among relatively few, highly leveraged
companies. Here, I think, is the principal explanation of why the busts
in dot-com stock prices and in the housing and mortgage markets had such
markedly different effects. In the case of dot-com stocks, losses were
spread relatively widely across many types of investors. In contrast,
following the housing and mortgage bust, losses were felt
disproportionately at key nodes of the financial system, notably highly
leveraged banks, broker-dealers, and securitization vehicles. Some of
these entities were forced to engage in rapid asset sales at fire-sale
prices, which undermined confidence in counterparties exposed to these
assets, led to sharp withdrawals of funding, and disrupted financial
intermediation, with severe consequences for the economy.
Private-sector risk management also failed to keep up with
financial innovation in many cases. An important example is the
extension of the traditional originate-to-distribute business model to
encompass increasingly complex securitized credit products, with
wholesale market funding playing a key role. In general, the
originate-to-distribute model breaks down the process of credit
extension into components or stages–from origination to financing and
to the postfinancing monitoring of the borrower’s ability to repay–in a
manner reminiscent of how manufacturers distribute the stages of
production across firms and locations. This general approach has been
used in various forms for many years and can produce significant
benefits, including lower credit costs and increased access of consumers
and small and medium-sized businesses to capital markets. However, the
expanded use of this model to finance subprime mortgages through
securitization was mismanaged at several points, including the initial
underwriting, which deteriorated markedly, in part because of incentive
schemes that effectively rewarded originators for the quantity rather
than the quality of the mortgages extended. Loans were then packaged
into securities that proved complex, opaque, and unwieldy; for example,
when defaults became widespread, the legal agreements underlying the
securitizations made reasonable modifications of troubled mortgages
difficult. Rating agencies’ ratings of asset-backed securities were
revealed to be subject to conflicts of interest and faulty models. At
the end of the chain were investors who often relied mainly on ratings
and did not make distinctions among AAA-rated securities. Even if the
ultimate investors wanted to do their own credit analysis, the
information needed to do so was often difficult or impossible to obtain.
Dependence on short-term funding, high leverage, and inadequate
risk management were critical vulnerabilities of the private sector
prior to the crisis. Derivative transactions further increased risk
concentrations and the vulnerability of the system, notably by shifting
the location and apparent nature of exposures in ways that were not
transparent to many market participants. But even as private-sector
activities increased systemic risk, the public sector also failed to
appreciate or sufficiently respond to the building vulnerabilities in
the financial system–both because the statutory framework of financial
regulation was not well suited to addressing some key vulnerabilities
and because some of the authorities that did exist were not used
effectively.
In retrospect, it is clear that the statutory framework of
financial regulation in place before the crisis contained serious gaps.
Critically, shadow banking activities were, for the most part, not
subject to consistent and effective regulatory oversight. Much shadow
banking lacked meaningful prudential regulation, including various
special purpose vehicles, ABCP conduits, and many nonbank
mortgage-origination companies. No regulatory body restricted the
leverage and liquidity policies of these entities, and few if any
regulatory standards were imposed on the quality of their risk
management or the prudence of their risk-taking. Market discipline,
imposed by creditors and counterparties, helped on some dimensions but
did not effectively limit the systemic risks these entities posed.
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