William C Dudley: Lessons from the financial crisis
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Economic Club of New York, New York City, 6 November 2017.
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James Bergen, Caren Cox, Gerard Dages, Beverly Hirtle, Anna Kovner, Lisa Kraidin, Lorie
Logan, Jonathan McCarthy, and Kevin Stiroh assisted in the preparation of these remarks
It is a pleasure to have the opportunity today to speak again at the Economic Club of New York.
As we mark the tenth anniversary of the onset of the financial crisis, I would like to focus on
some of the lessons we should draw from that harrowing experience, and the implications of
those lessons for regulatory policy going forward. As always, what I have to say reflects my own
views and opinions and not necessarily those of the Federal Open Market Committee or the
Federal Reserve System.
The first lesson is that financial crises can have grave consequences-for the economy and the
nation-that can linger for many years. The toll from the financial crisis was severe, with nine
million jobs lost and eight million housing foreclosures amid the deepest economic downturn
since the Great Depression. Moreover, the road back has been long and slow. Despite
economic policies oriented toward supporting recovery, it has taken eight years to push the
unemployment rate down to a level consistent with the Federal Reserve's employment objective.
Other residual impacts include the large size of the Federal Reserve's balance sheet;
significantly higher public debt; and substantial damage to public trust in the nation's government
and financial institutions.
The second lesson follows from the first. We need to ensure that we have a resilient financial
system. To that end, we must ensure that the safeguards put in place in response to the crisis
are fully appreciated and respected. But, it also means that we need to finish the job-for
example, by building out a fully workable regime for resolving a complex, global firm if one were
to become insolvent. We need to ensure that our financial system can continue to provide
critical services not just during good times, but also during periods of stress.
These objectives are particularly relevant today, when reopening the Dodd-Frank Act and
modifying our regulatory framework are under consideration. While it is appropriate to evaluate
adjustments that might improve our regulatory regime, it is critical that we do not forget the
hardlearned lessons of the crisis and-in the haste to reverse course-undermine the robustness
and resiliency of the financial system.
The U.S. housing market boom and bust
At the heart of the crisis was the U.S. housing boom and bust. Between 1997 and 2006, U.S.
home prices nearly doubled in real terms on a national basis. Then, when the boom turned to
bust, real home prices reversed course, declining by about 40 percent on a national basis, with
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larger price declines in several states. The magnitude of the national price declines was
unprecedented during the postwar period.
The evolution of the financial crisis illustrates a number of key issues, including the potential
hazards of financial innovation, the procyclicality of the financial system, and the importance of
confidence in sustaining effective financial intermediation.
The housing boom resulted from several factors. Innovations in subprime mortgage lending
enabled moderate-income households to purchase homes with negligible down payments. This
led to an increase in the demand for housing, which helped push up home prices. Home price
appreciation masked the potential riskiness of such lending and, in turn, sustained the wisdom of
the easier underwriting standards. As long as home values were rising, subprime borrowers
could either refinance their loans or sell their homes when the initial teaser rates expired. Thus,
losses on subprime and other mortgage lending were low, reinforcing the belief that such loans
were "safe."
Easier mortgage underwriting practices were also supported by the ability of mortgage
originators to pool their mortgages into collateralized debt obligations (CDOs), transforming
lowquality assets into triple-A-rated securities. Investors, including banks, relied too heavily on credit
ratings and didn't do sufficient due diligence on the underlying quality of the assets and the
assumptions that underpinned the triple-A ratings. Implicit in these ratings was the assumption
that a large, national decline in home prices was extraordinarily unlikely.
The rise in home prices led to a surge in construction activity, which helped to sustain the
housing boom for a time. This effect was particularly powerful in states such as Arizona,
California, Florida, and Nevada. Rising home prices also bolstered the economy by supporting
consumption, as households monetized these gains by cash-out refinancings and home equity
lines of credit.
The housing boom was also supported by an accompanying financial boom. The financing
activity associated with the surge in mortgage originations and securitizations pushed up the
earnings of the major banking and securities firms. These strong earnings created incentives to
ease underwriting standards further.
But, as housing supply responded to the increase in home prices-housing starts rose from a
1.5 million annual rate in mid-2000 to a 2.3 million annual rate in early 2006-the positive
feedback loop began to run in reverse. Home prices began to soften, subprime borrowers found
it more difficult to refinance, and mortgage loan defaults and delinquencies rose. As the bust got
underway in earnest, residential investment declined and consumer spending was undercut as
home equity levels fell.
The housing boom and bust underscores several important lessons. First, the financial sector is
not only a very complex system, but also one that can be inherently unstable-subject to excess,
then sharp reversal. This is especially the case when an important innovation occurs and
market participants don't fully appreciate the powerful feedback loops that first sustain a boom
and then contribute to a bust when the process runs in reverse. This means that we as
regulators must continually evaluate the financial system and monitor the landscape for new
developments and innovations that, if taken too far, could lead to excess and put the system at
risk.
Second, when there are potential excesses that could threaten financial stability, we should look
to temper them. For example, in the run-up to the financial crisis, macroprudential tools-such
as requiring larger down payments or more closely evaluating the incomes of borrowers-could
have been implemented to limit the demand for housing. If such an approach were successful,
home prices would not have risen so dramatically, and the subsequent bust would have been
less severe. Another approach would have required financial intermediaries to build stronger
capital and liquidity buffers as protection against a housing bust and an economic downturn.
Prior to the financial crisis, the conventional wisdom was that asset bubbles could not be
identified in real time-rather, they could only be cleaned up after they burst. While there are
significant challenges to identifying asset bubbles, it is clear that cleaning up only after they burst
does not always work out well in practice.
Third, we need to carefully monitor the incentives that govern the behavior of borrowers, savers,
and financial intermediaries.
During the crisis, some examples of bad incentives that sustained the boom included:
1. Compensation practices at financial firms that rewarded volume and short-term
performance over longer-term, sustainable returns;
2. The conflict of interest inherent in the willingness of the credit rating agencies to designate
tranches of subprime mortgages triple-A in exchange for fees;
3. The ability of Fannie Mae and Freddie Mac to use their implicit government support to take
on large amounts of mortgage risk with very little capital backing; and,
4. The ability of AIG to use its triple-A rating to provide credit protection to banks and securities
firms against complex mortgage obligations with little direct capital support or an adequate
liquidity backstop.
Culmination of the crisis
Once the housing bust got underway, stress on the financial system increased sharply as asset
prices fell and bank earnings plunged. In the spring of 2008, such pressures led to a forced sale
of Bear Stearns to JPMorgan Chase. Later in the year, the government placed Fannie Mae and
Freddie Mac into conservatorship. In September, Lehman Brothers failed. And, a day later, AIG
was rescued in order to protect the rest of the financial system against further losses and even
broader contagion. With confidence in financial markets and financial intermediaries badly
frayed, the Federal Reserve and the U.S. government intervened and provided a range of liquidity
backstops, debt guarantees, and capital infusions to forestall a complete collapse of the financial
system and the economy.
The bust exposed many structural flaws in the financial system that exacerbated its instability.
Without being exhaustive, these included the instability of the tri-party repo system, which
supported the nation's short-term funding markets; the risks of runs in the money market mutual
fund industry; and the risk of contagion caused by the huge volume of outstanding bilateral
(noncentrally cleared) over-the-counter (OTC) derivative obligations between the major financial
intermediaries.
The tri-party repo system was centered on two of the major U.S. banks. The system matched
investors and borrowers each day-with the investors lending cash, secured by Treasuries and
other collateral, to the major securities firms. But, the system was unstable. In times of stress,
clearing banks could be faced with very large single-firm exposures-of potentially hundreds of
billions of dollars. Not surprisingly, when such counterparties became troubled, the clearing
banks were less willing to take on these large intraday exposures. As a result, repo investors,
who were primarily worried about getting repaid each morning, were motivated to simply
withdraw from the market. As short-term investors withdrew funding, the liquidity buffer of the
troubled securities firm was quickly exhausted, particularly as other counterparties to that firm
demanded additional collateral to secure their own exposures.
Structural weaknesses in the money market mutual fund industry-which was a major source of
short-term wholesale funding to the securities industry and various non-bank financial
corporations-also exacerbated the crisis. When Lehman Brothers failed, the value of its
outstanding short-term obligations collapsed. The Reserve Primary Fund "broke the buck," and
investors rushed to withdraw their funds from prime institutional money market mutual funds in a
modern version of a classic "bank run." The funds generally did not have sufficient cash
available to meet these runs because they offered overnight liquidity at par value against a
portfolio of assets with weighted average maturities that were considerably longer.
Another important source of instability was the large volume of bilateral OTC derivatives positions
outstanding among the major firms and the right of a firm to immediately close out such positions
if their counterparty became insolvent. For example, when Lehman Brothers failed in September
2008, counterparties to Lehman terminated OTC derivatives in which the contract was in the
money (i.e., Lehman owed money to the counterparty) and liquidated the collateral held against
those obligations, but kept open obligations in which the exposure went the other way, from them
to Lehman. Not only did this create an imbalance in the risk exposures of the failed firm, but it
also generated significant market churn and risk as firms scrambled to rebalance their own risk
exposures. The contagion generated by the complex web of outstanding bilateral OTC derivative
exposures significantly worsened the crisis and was responsible for much of the losses Lehman
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incurred in its bankruptcy.
The near-collapse of the U.S. financial system underscores three critical lessons.
First, financial institutions must be robust to stress. In particular, they need to have enough
capital to be considered solvent even after sustaining significant losses, so that they can
maintain the market access needed to recapitalize. They also need sufficient liquidity buffers so
that they can respond to shocks without having to sell illiquid assets. The forced sale of illiquid
assets can push asset valuations far below their fundamental value, which can increase
insolvency risk. And, it is important that they not be overly reliant on short-term wholesale
funding, which can evaporate during times of stress.
Second, when we identify potential sources of instability that could amplify shocks, we need to
make structural changes to the financial system to reduce or eliminate them. For example, the
financial crisis made it clear that changes were needed in how tri-party repo transactions were
unwound each day, net asset values were calculated for prime money market mutual funds, and
OTC derivative obligations were cleared, settled, and risk-managed.
Third, there should be a viable and predictable resolution regime. We need to be able to resolve a
large, systemically important bank or securities firm in a way that limits contagion and stress on
the rest of the financial system, while at the same time protecting the taxpayer against loss.
Meanwhile, central counterparties (CCPs)-through which most standardized OTC derivatives
must now be cleared-need to be open for business for the financial system to operate
effectively. Here, the emphasis should be on ensuring that these financial market utilities can
open for business the day after the failure of one or more of their participants. Credible resolution
regimes for large banks and securities firms-and credible recovery regimes for CCPs and other
critical financial market utilities-should help support confidence during times of stress.
These measures would make the financial system less prone to booms and busts. Financial
intermediaries would be more robust to stress when busts inevitably occur, and contagion to the
broader system would be reduced when a systemically important firm fails. Such changes
should reduce the likelihood of the failure of a large, systemically important firm and the negative
consequences of such a failure on the broader financial system. These steps should help to
ensure that credit flows can be sustained throughout the business cycle.
Considerable progress
So, where are we relative to what is needed? As I see it, there has been considerable progress.
The nation's largest banks are much safer as a result of substantially higher capital and liquidity
requirements, as well as robust stress tests. This enhanced resiliency has been achieved
without a significant negative impact on the broad availability of credit-recognizing that it is now
more difficult for households with low credit scores to obtain a mortgage. Most importantly,
improving the capacity of such firms to continue to lend during times of stress should make the
overall economy more stable.
We have also made significant progress in addressing many of the structural weaknesses
uncovered by the financial crisis. Money market reform has made the prime money market
mutual fund industry smaller and safer. The elimination of the net asset value convention for
institutional prime money market mutual funds has made these funds smaller and less prone to
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runs during times of crisis. The tri-party repo system has been made more stable as intraday
exposures of the large clearing banks have been dramatically reduced. This means that they
have less reason to back away from a firm if it were to become troubled. And, firms are much
less reliant on short-term wholesale funding.
We have also reduced the amount of risk in the system by requiring that most standardized OTC
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derivatives be cleared through CCPs, where multilateral netting occurs. In a centrally cleared
regime, major intermediaries have net exposures to individual CCPs that replace much larger
bilateral exposures to other financial intermediaries. Of course, this means putting more eggs in
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the CCP basket. So, it is particularly important now to closely watch that basket. Greater
oversight of CCPs is necessary to ensure that they have good governance, sound risk
management, robust technological infrastructures, and adequate liquidity support. In addition, we
have made considerable progress in developing a viable resolution regime for large, systemically
important banks and securities firms.
More work is still needed
Yet, we should not be complacent, as there are important areas where our work is not
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complete. Relative to other countries, the United States has limited ability to implement
effective macroprudential tools. That is because oversight is shared by several different entities,
and the power to implement macroprudential tools is constrained. Another challenge is the
diverse structure of the U.S. financial system, in which non-banks and capital markets play a
substantial role in credit intermediation. Although the Financial Stability Oversight Council
(FSOC) could conceivably play a greater role here, whether it will be able to do so effectively
remains uncertain.
Another issue that needs attention is the ability to resolve large, complex financial firms that
operate on a global basis. The framework of requiring such firms to hold a large buffer of debt
that could be converted into equity at the time of non-viability is an important step forward. But,
the task of operationalizing this on a global basis in a way that is fully credible to these firms'
customers and counterparties has not been completed. Achieving clarity about the roles and
responsibilities of home and host country authorities is still a work in progress.
The Federal Reserve's lack of authority to lend to a major securities dealer that gets into difficulty
is another outstanding issue. The Dodd-Frank Act narrowed the Federal Reserve's authority
under Section 13(3) of the Federal Reserve Act. No longer can the Federal Reserve lend to an
individual securities firm or non-bank financial intermediary. Such authority may not be as
necessary now that the Federal Deposit Insurance Corporation (FDIC) has the power to lend
under Title II of the Dodd-Frank Act and firms are required to have sufficient resources to support
their resolution plans. But, I would prefer having such a tool available in extremis given the
potential need to buy time for coordination and critical decision-making. I think it is important to
ensure that one can "get to the weekend." Finally, the work needed to ensure that CCPs can
always recover has not yet been completed. This is an issue of increased importance given that
their role in the financial system has become more prominent.
Where the pendulum may have swung too far
At the same time, there are some areas where the pendulum may have swung too far, where the
costs of regulation-including compliance costs and the potential impact on the provision of
services-are likely to exceed the benefits. In this vein, I favor regulatory relief for smaller
banking organizations. First, such firms individually are not systemically important, and therefore
do not pose a significant risk to the viability of the U.S. financial system. Second, the regulatory
burdens on smaller firms can be heavy because they don't have the scale over which
compliance and other regulatory costs can be spread. Regulatory requirements should be
appropriately calibrated to avoid inadvertently creating a competitive advantage for larger financial
firms.
I also think that the Volcker rule could be modified so that its implementation would be less
burdensome. As I see it, regulators could review the criteria for permissible market-making.
Trading activity should be viewed as market-making when it is customer-facing and inventories
are not excessively large or stale. Market-making serves an important function, and it is important
that trading desks can intervene and buy during flash crashes or sell during flash
surges. Permitting this could provide greater liquidity and stability to financial markets. I would
also exempt smaller banking institutions from the Volcker rule since they rarely, if ever, engage in
proprietary trading.
Do no harm
Many speculate that Congress will make changes to the Dodd-Frank Act. If the scope is
confined mainly to small bank relief and adjusting how the Volcker rule is applied, I have no
objection. But, because the Dodd-Frank Act addresses many of the key lessons of the crisis, I
think it appropriate that changes be made carefully-with a paring knife, rather than with a meat
cleaver. Here, I would underscore the importance of preserving higher capital and liquidity
requirements for systemically important banks; Title VII, which mandates the central clearing of
standardized OTC derivatives; and Title VIII, which gives the Federal Reserve an oversight role
for financial market utilities that are systemically important, and which helps promote more
uniform risk management standards.
While Title II gives the FDIC the authority to resolve a large, complex financial firm by converting
its debt into equity and establishing a new holding company, I do not think this is necessarily the
only way to have a viable resolution regime. However, if Title II were to be eliminated, then the
Bankruptcy Code would need to be bolstered. There are two essential requirements: the ability
to initiate an effective resolution strategy over the weekend, and a government entity-be it the
Federal Reserve or the FDIC-that can provide a credible liquidity backstop to the recapitalized
entity when it opens for business on Monday morning. If resolution cannot be accomplished in
this timeframe, confidence would suffer and there would be contagion. Without a credible
liquidity backstop, clients and counterparties would run, making it much more difficult for the
recapitalized firm to conduct its business.
I would also preserve the authority of the FSOC to designate non-banking firms as systemically
important and subject to supervision by the Federal Reserve. As I see it, the designations of GE
Capital and AIG were successful in two important respects. First, Federal Reserve supervision
resulted in improved corporate governance and risk management. Second, it created incentives
for the firms to alter their operations to become less systemically important in order to be
dedesignated. We should also retain this designation tool because we cannot predict which firms
and activities may emerge and become systemically important in the future. After all, I do not
think many were focused on or worried about the activities of AIG's Financial Products Group
several years before the financial crisis, though in retrospect those activities proved to be
systemically important. That part of the firm should have been better supervised and regulated.
Summing up
In conclusion, as we reflect on potential changes to the U.S. regulatory regime, we should not
lose sight of the horrific damage caused by the financial crisis, including the worst recession of
our lifetimes and millions of people losing their jobs and homes. We had a woefully inadequate
regulatory regime in place, and while it is much better now, there is still work to do. We should
finish the job as quickly as possible, and we should do no harm as we adjust our regulatory
regime to make it more efficient.
Thank you for your kind attention. I would be happy to take a few questions.
the deflator.
2
For more background, see Fleming and Sarkar, The Failure Resolution of Lehman Brothers, December 2014.
3
For more background, see Chen, Cipriani, La Spada, Mulder and Shah, Money Market Funds and the New SEC
Regulation, March 20, 2017, and Cipriani, La Spada and Mulder, Investors' Appetite for Money-Like Assets: The
Money Market Fund Industry after the 2014 Regulatory Reform, June 2017.
4
For more detail, see Tri-party Repo Infrastructure Reform.
5
For more background, see Over-the-Counter Derivatives.
6
To paraphrase Andrew Carnegie and Mark Twain.
7
For related remarks, see William C. Dudley, Principles for Financial Regulatory Reform, April 7, 2017.