NEW YORK (MNI) – The following is the second of five sections of
the text of remarks of Simon Potter, executive vice president, New York
Federal Reserve Bank, prepared Monday for the Third Annual Connecticut
Bank and Trust Company Economic Outlook Breakfast:

Phase 2: Unusual and Exigent

On Tuesday March 11, 2008, the Federal Reserve announced an
expansion of its standard securities lending program for primary
dealers3 to a facility that accepted a wider range of collateral and
lent at a term longer than overnight. This new facility, known as the
Term Securities Lending Facility (TSLF), was designed to help ease the
ongoing erosion of liquidity conditions in funding markets that was
occurring despite the two large cuts in the fed funds target in January
2008.

Two days later after the Federal Reserve announced the TSLF, Bear
Stearns Co., the fifth largest investment bank in the U.S., ran out of
cash to meet its obligations for the next day. Over the ensuing three
days, the Federal Reserve, working with the Securities and Exchange
Commission and U.S. Treasury, facilitated the takeover of Bear Stearns
by JPMorgan Chase. The Federal Reserve used a lender-of-last-resort
authority it had been granted in the 1930s under Section 13(3) of the
Federal Reserve Act to facilitate the transaction. Further, on that
Sunday, March 16, the Federal Reserve announced the introduction of the
Primary Dealer Credit Facility (PDCF), an emergency extension of the
standard discount window facilities to primary dealers.

Finally two days later on March 18, the Federal Open Market
Committee (FOMC) cut the fed funds target by 75 basis points, bringing
the total decrease in the target since the start of the crisis to 300
basis points. At that time, many saw this point as the peak of the
crisis and assumed that the weaknesses in the financial and regulatory
system would be fixed as the crisis subsided.

At this point, it is worth spending a moment to explain in a little
more detail the basic elements of Section 13(3) of the Federal Reserve
Act, a provision that had only previously been used for relatively small
loans in the 1930s.4 Section 13(3) allows a Federal Reserve Bank to lend
to any individual, partnership or corporation under the authority of a
super-majority of the Federal Reserve Board in unusual and exigent
circumstances, if adequate credit accommodations are not available from
other banking institutions and if the Federal Reserve Bank is secured to
its satisfaction. This last condition effectively represents the
dividing line between lender-of-last-resort actions on one hand and
capital injections or other forms of unsecured lending on the other
hand, a critically important dividing line the Federal Reserve carefully
respected in all its actions over the course of the crisis.

One lesson that emerges from this and later phases of the crisis is
that while the Federal Reserve’s authority and accountability for the
13(3) actions taken in March 2008 and throughout the crisis were well
established under the Federal Reserve Act, what was crucially lacking
was a public transparency regime that would allow the public to
immediately track and understand the details of the extraordinary action
taken. The complexity of creating a robust, responsible and safe
transparency regime in the midst of rapid change and extreme market
fragility notwithstanding, the fact that the public transparency of the
central bank might lag the actions being taken by the central bank
creates its own set of risks. In fact, the importance of transparency
keeping pace with actions was actually the main theme of Greenspan’s
1996 speech, where, just as an aside, he had coined the phrase
irrational exuberance. One paragraph in particular seems particularly
prescient:

“If we are to maintain the confidence of the American people, it is
vitally important that, excepting the certain areas where the premature
release of information could frustrate our legislated mission, the Fed
must be as transparent as any agency of government. It cannot be
acceptable in a democratic society that a group of unelected individuals
are vested with important responsibilities, without being open to full
public scrutiny and accountability.”

As I previously noted, establishing an appropriate and responsible
transparency regime for emergency lending in the midst of a severe
crisis is an especially challenging task. With sufficient time to assess
the maximum amount of information that could be released without
frustrating its mission, the Federal Reserve now discloses extremely
detailed information to the public about all of its facilities.5
However, the fact that such information was not instantly available gave
rise to public criticism.

Another lesson that emerged strongly in this phase of the crisis
was the need for adding to the regulatory toolkit a robust and effective
method for resolving complex financial institutions without imperiling
the safety of the broader system. In the case of Bear Stearns, the
presence of a willing acquirer presented the opportunity for an assisted
transaction that effectively amounted to an ad hoc resolution mechanism
for the failing firm. One sense in which this solution was ad hoc was
that policymakers could not be sure that a willing acquirer would be
found in the case of distress in the future, but another, perhaps more
important sense is that the rules of the game were not clearly
established in advance.

In this context, it is worth noting that the United States had led
the world with its Federal Deposit Insurance Corporation (FDIC)
Improvement Act in 1991 in establishing a state-of-the-art resolution
regime for depository institutions to avoid the panics and runs
associated with the risk of insolvency of a financial institution, while
at the same time protecting the taxpayers. However, this regime did not
address how to efficiently resolve holding companies that included a
depository institution, investment banks or other financial institutions
that were tightly and very intricately woven into the global financial
system.

Perhaps because many thought that March 2008 was the height of the
crisis, the overwhelming importance of this lesson coming out of the
Bear Stearns episode did not translate into this gap in our regulatory
framework being addressed with sufficient urgency. As I will discuss
momentarily, the gap re-emerged as a main accelerant of the crisis with
the collapse of Lehman Brothers in September of that same year.
Although, it is worth acknowledging in this context that Congress did
approve legislation setting up a special contingent resolution process
for the government-sponsored enterprises (GSEs) in the summer of 2008.

A final lesson from this phase of the crisis was the critical need
for policymakers to question the validity of the assumptions that are
often taken for granted in assessing the risks to financial stability.
For example, most macroeconomic models do not have an explicit banking
sector. Thus, in simulations of the effects of house price declines, the
main channel of propagation is an indirect one through a wealth effect
on consumption. As house prices continued to decline at unprecedented
rates, many analysts started to reconsider the adequacy of what had
previously been considered ample capital in the U.S. banking system, and
thus the extent to which this capital would be a firebreak against a
significantly sharper contraction. If this firebreak was insufficient or
perceived to be insufficient, then these analysts correctly anticipated
that a vicious adverse feedback loop might take hold: declines in
economic activity would make financial institutions reluctant to lend in
order to conserve capital for possible credit losses, the decline in
lending would further reduce economic activity and so on. This type of
nonlinearity had not been part of pre-crisis evaluation of the risks of
large house price declines, but by the spring of 2008, it was becoming a
central concern.

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