NEW YORK (MNI) – The following is 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:
Among the many important lessons coming out of the global financial
crisis that started in the summer of 2007, possibly the most important
revolve around how complex the global financial system is, how quickly
confidence in that system can deteriorate, and how difficult it is to
come up with simple and robust solutions to stabilize the system in real
time. My remarks today will break the progression of this crisis into
four distinct phases. In doing so, my intention is to highlight some of
the actions taken by the Federal Reserve to manage the crisis, and to
offer what at least in retrospect seem to be clear lessons on how to
promote financial stability outside the heat of a crisis.
The four distinct phases of the recent crisis were as follows:
— The initial disruption in money markets in the summer of 2007I
will call this the “what are these securities worth?” phase;
— The abrupt takeover of Bears Stearns by JPMorgan ChaseI will
call this the “unusual and exigent” phase;
— The 30 days following the bankruptcy of Lehman BrothersI will
call this the “panic” phase; and
— The period from mid-November 2008 to early May 2009I will call
this the “viability of large U.S. banking organizations” phase.
One consistent theme that emerges across all these phases is that
central banks must have the ability to respond quickly and flexibly in a
crisis situation. This ability is crucial in preventing the emergence of
an adverse feedback loop between instability in the financial system and
weakness in the real economy. Another theme that emerged as these phases
played out, however, was that an ability to move with speed and
flexibility comes with the challenge of ensuring that accountability and
transparency keep pace with the actions being taken. The need for
accountability and transparency is especially true when central bank
actions are being used to innovatively fill holes in a regulatory and
legal framework that has not kept pace with the evolution of the
financial system.
Phase 1: What Are These Securities Worth?
On August 9, 2007, the large French bank BNP Paribas announced that
it had suspended activity in three of its funds so it could more
precisely assess their value. The problem was stated as follows:
“The complete evaporation of liquidity in certain market segments
of the U.S. securitization market has made it impossible to value
certain assets fairly regardless of their quality or credit rating.”
Central banks immediately responded to the evaporation of liquidity
in the standard manner. For example, the Federal Reserve issued a
statement on August 10 indicating it was providing liquidity for the
orderly functioning of markets, and in that statement the Federal
Reserve emphasized that “As always, the discount window is available as
a source of funding.”One week later it reinforced this statement with a
50 basis point cut in the discount rate and the addition of 30-day term
loan to complement the standard overnight discount window loan.
At that time, the discount windows of Federal Reserve Banks were
only open to depository institutions. Standard monetary economic theory
and previous experience were consistent with the notion that depository
institutions could act as intermediaries to pass liquidity through to
the rest of the financial system. Indeed, in many earlier episodes the
mere fact that this backstop liquidity was present had been sufficient
to calm financial markets.
Circumstances proved very different in this episode. For one, the
rise of the shadow banking system meant that a preponderance of
financial intermediation in the United States was being performed by
non-depository institutions that funded themselves in wholesale rather
than retail markets. Further, traditional discount window loans have
always been vulnerable to stigmathat is, if a bank borrows from the
central bank it runs the risk that markets and counterparties may infer
that it is closer to insolvency than was previously thought.
The potential for stigma to damage the effectiveness of this
crucial backstop facility explains why the identity of discount window
borrowers is not disclosed by the Federal Reserve. Indeed, we saw early
in this crisis that many depository institutions proved unwilling to
take the risk of possible stigma, the result of which was an
increasingly severe impairment to the flow of liquidity to the rest of
the financial system. In late August 2007, a new facility was designed
to help overcome stigma through the use of an auction mechanism. As the
market calmed in September to late October, this facility was shelved
but was ultimately introduced on December 12, 2007, as the Term Auction
Facility in a coordinated announcement with other central banks.
This phase has some obvious lessons for financial stability.
— Financial products that are new and complex should be treated
with caution. Regulators, credit rating agencies and market participants
all have limited ability to evaluate the properties of such complex
products at their inception. For example, the fact that the credit
rating agencies bestowed their highest ratings on certain securities
prior to the crisis meant that many investors assumed that the
securities were “informationally insensitive.” What was subsequently
learned, however, was that instead of being robust to economic
developments, structure of the securities had merely served to
concentrate the systemic “tail risk” in the securities.
— New financial products are often associated with the extension
of primary credit to previously underserved sectors of the economy. This
extension of credit to the previously underserved often produces abuses
or outright fraud, much of which can be masked by the newness and
complexity of the products.
In many respects these are old lessons that we should have learned
already from what occurred in the run-up to previous episodes of
financial crisis. However, the remarkable stability of the U.S. economy
from the mid-1980s to 2007 unfortunately served to produce what amounted
to a collective amnesia with regard to these earlier learned lessons.
For example, most macroeconomists had become convinced that the widening
and deepening of the financial system over the previous twenty years
driven by deregulation, and given additional impetus by the return to
low and stable inflation, was an important source for this economic
stability.
This is not to say that there was no one pointing out the risks of
the low risk premiums and the rapid growth of structured investment
products, but many economists, analysts and commentators had reached the
blissful state of mind that it was different this time. In this context,
it is useful to recall an unease articulated by former Federal Reserve
Board Chairman Alan Greenspan in 19962:
“Clearly, sustained low inflation implies less uncertainty about
the future, and lower risk premiums imply higher prices of stocks and
other earning assets. But how do we know when irrational exuberance has
unduly escalated asset values…?”
This uncertainty about the link between underlying fundamentals and
current asset valuations is crucial to interpreting this initial phase
of the crisis. For example, one relatively benign interpretation of what
was playing out was that the financial system was experiencing a
liquidity problem driven by a maturity mismatch in the shadow banking
system. The liquidity problem was unusually severe because of the
collapse of the shadow banking sector and the resulting pressures that
collapse placed on the balance sheets and liquidity positions of the
traditional bank sector. Nonetheless, the situation was fundamentally
viewed as a liquidity problem rather than a solvency problem, meaning
that any potential credit losses were likely to be small and easily
absorbed.
An alternative darker view was that the global financial system was
overexposed to land prices in the United States, through the home sale
and mortgage refinancing boom that had taken place in the last four
years. This darker view was given less credence, in part because the
magnitude of the fall in U.S. nominal house prices necessary to produce
a situation where the losses could not be easily absorbed was viewed by
many as implausibly large. At that time, the conventional view was that
by standard regulatory and accounting measures, most U.S. financial
institutions had more than ample capital against the risks they faced.
Furthermore, institutions were raising new capital to fill the reduction
in accounting capital being produced by the write-downs associated with
subprime related assets.
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