Ben S Bernanke: Stabilizing the financial markets and the economy
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Economic Club of New York, New York, 15 October 2008.
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Good afternoon. I am pleased once again to share a meal and some thoughts with the
Economic Club of New York. I will focus today on the economic and financial challenges we
face and why I believe we are well positioned to move forward. The problems now evident in
the markets and in the economy are large and complex, but, in my judgment, our
government now has the tools it needs to confront and solve them. Our strategy will continue
to evolve and be refined as we adapt to new developments and the inevitable setbacks. But
we will not stand down until we have achieved our goals of repairing and reforming our
financial system and restoring prosperity.
The crisis we face in the financial markets has many novel aspects, largely arising from the
complexity and sophistication of today's financial institutions and instruments and the
remarkable degree of global financial integration that allows financial shocks to be
transmitted around the world at the speed of light. However, as a long-time student of
banking and financial crises, I can attest that the current situation also has much in common
with past experiences. As in all past crises, at the root of the problem is a loss of confidence
by investors and the public in the strength of key financial institutions and markets. The crisis
will end when comprehensive responses by political and financial leaders restore that trust,
bringing investors back into the market and allowing the normal business of extending credit
to households and firms to resume. In that regard, we are, in one respect at least, better off
than those who dealt with earlier financial crises: Generally, during past crises, broad-based
government engagement came late, usually at a point at which most financial institutions
were insolvent or nearly so. Waiting too long to respond has usually led to much greater
direct costs of the intervention itself and, more importantly, magnified the painful effects of
financial turmoil on households and businesses. That is not the situation we face today.
Fortunately, the Congress and the Administration have acted at a time when the great
majority of financial institutions, though stressed by highly volatile and difficult market
conditions, remain strong and capable of fulfilling their critical function of providing new credit
for our economy. This prompt and decisive action by our political leaders will allow us to
restore more normal market functioning much more quickly and at lower ultimate cost than
would otherwise have been the case. Moreover, we are seeing not just a national response
but a global response to the crisis, commensurate with its global nature.
This financial crisis has been with us for more than a year. It was sparked by the end of the
U.S. housing boom, which revealed the weaknesses and excesses that had occurred in
subprime mortgage lending. However, as subsequent events have demonstrated, the
problem was much broader than subprime lending. Large inflows of capital into the United
States and other countries stimulated a reaching for yield, an underpricing of risk, excessive
leverage, and the development of complex and opaque financial instruments that seemed to
work well during the credit boom but have been shown to be fragile under stress. The
unwinding of these developments, including a sharp deleveraging and a headlong retreat
from credit risk, led to highly strained conditions in financial markets and a tightening of credit
that has hamstrung economic growth.
The Federal Reserve responded to these developments in two broad ways. First, following
classic tenets of central banking, the Fed has provided large amounts of liquidity to the
financial system to cushion the effects of tight conditions in short-term funding markets.
Second, to reduce the downside risks to growth emanating from the tightening of credit, the
Fed, in a series of moves that began last September, has significantly lowered its target for
the federal funds rate. Indeed, last week, in an unprecedented joint action with five other
major central banks and in response to the adverse implications of the deepening crisis for
the economic outlook, the Federal Reserve again eased the stance of monetary policy. We
will continue to use all the tools at our disposal to improve market functioning and liquidity, to
reduce pressures in key credit and funding markets, and to complement the steps the
Treasury and foreign governments will be taking to strengthen the financial system.
Notwithstanding our efforts and those of other policymakers, the financial crisis intensified
over the summer as mortgage-related assets deteriorated further, economic growth slowed,
and uncertainty about the financial and economic outlook increased. As investors and
creditors lost confidence in the ability of certain firms to meet their obligations, their access to
capital markets as well as to short-term funding markets became increasingly impaired, and
their stock prices fell sharply. Prominent companies that experienced this dynamic most
acutely included the government-sponsored enterprises (GSEs) Fannie Mae and Freddie
Mac, the investment bank Lehman Brothers, and the insurance company American
International Group (AIG).
The Federal Reserve believes that, whenever possible, the difficulties experienced by firms
in financial distress should be addressed through private-sector arrangements - for example,
by raising new equity capital, as many firms have done; by negotiations leading to a merger
or acquisition; or by an orderly wind-down. Government assistance should be provided with
the greatest reluctance and only when the stability of the financial system, and thus the
health of the broader economy, is at risk. In those cases when financial stability is broadly
threatened, however, intervention to protect the public interest is not only justified but must
be undertaken forcefully and without hesitation.
Fannie Mae and Freddie Mac present cases in point. To avoid unacceptably large
dislocations in the mortgage markets, the financial sector, and the economy as a whole, the
Federal Housing Finance Agency put Fannie and Freddie into conservatorship, and the
Treasury, drawing on authorities recently granted by the Congress, made financial support
available. The government's actions appear to have stabilized the GSEs, although, like
virtually all other firms, they are experiencing effects of the current crisis. We have already
seen benefits of their stabilization in the form of lower mortgage rates, which will help the
housing market.
The difficulties at Lehman and AIG raised different issues. Like the GSEs, both companies
were large, complex, and deeply embedded in our financial system. In both cases, the
Treasury and the Federal Reserve sought private-sector solutions, but none was
forthcoming. A public-sector solution for Lehman proved infeasible, as the firm could not post
sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve
would be repaid, and the Treasury did not have the authority to absorb billions of dollars of
expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could
be done except to attempt to ameliorate the effects of Lehman's failure on the financial
system. Importantly, the financial rescue legislation, which I will discuss later, will give us
better choices. In the future, the Treasury will have greater resources available to prevent the
failure of a financial institution when such a failure would pose unacceptable risks to the
financial system as a whole. The Federal Reserve will work closely and actively with the
Treasury and other authorities to minimize systemic risk.
In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure
would have severely threatened global financial stability and the performance of the U.S.
economy. We also judged that emergency Federal Reserve credit to AIG would be
adequately secured by AIG's assets. To protect U.S. taxpayers and to mitigate the possibility
that lending to AIG would encourage inappropriate risk-taking by financial firms in the future,
the Federal Reserve ensured that the terms of the credit extended to AIG imposed significant
costs and constraints on the firm's owners, managers, and creditors.
AIG's difficulties and Lehman's failure, along with growing concerns about the U.S. economy
and other economies, contributed to extraordinarily turbulent conditions in global financial
markets in recent weeks. Equity prices fell sharply. Withdrawals from prime money market
mutual funds led them to reduce their holdings of commercial paper - an important source of
financing for the nation's nonfinancial businesses as well as for many financial firms. The
cost of short-term credit, where such credit has been available, jumped for virtually all firms,
and liquidity dried up in many markets. By restricting flows of credit to households,
businesses, and state and local governments, the turmoil in financial markets and the
funding pressures on financial firms pose a significant threat to economic growth.
The Treasury and the Fed have taken a range of actions to address financial problems. To
address illiquidity and impaired functioning in commercial paper markets, the Treasury
implemented a temporary guarantee program for balances held in money market mutual
funds to help stem the outflows from these funds. The Federal Reserve put in place a
temporary lending facility that provides financing for banks to purchase high-quality
assetbacked commercial paper from money market funds, thus reducing their need to sell the
commercial paper into already distressed markets. Moreover, we soon will implement a new,
temporary Commercial Paper Funding Facility that will provide a backstop to commercial
paper markets by purchasing highly rated commercial paper directly from issuers at a term of
three months when those markets are illiquid.
To address ongoing problems in interbank funding markets, the Federal Reserve has
significantly increased the quantity of term funds it auctions to banks and accommodated
heightened demands for temporary funding from banks and primary dealers. Also, to try to
mitigate dollar funding pressures worldwide, we have greatly expanded reciprocal currency
arrangements (so-called swap agreements) with other central banks. Indeed, this week we
agreed to extend unlimited dollar funding to the European Central Bank, the Bank of
England, the Bank of Japan, and the Swiss National Bank. These agreements enable foreign
central banks to provide dollars to financial institutions in their jurisdictions, which helps
improve the functioning of dollar funding markets globally and relieve pressures on U.S.
funding markets. It bears noting that these arrangements carry no risk to the U.S. taxpayer,
as our loans are to the foreign central banks themselves, who take responsibility for the
extension of dollar credit within their jurisdictions.
The expansion of Federal Reserve lending is helping financial firms cope with reduced
access to their usual sources of funding and thus is supporting their lending to nonfinancial
firms and households. Nonetheless, the intensification of the financial crisis over the past
month or so made clear that a more powerful, comprehensive approach involving the fiscal
authorities was needed to address these problems more effectively. On that basis, the
Administration, with the support of the Federal Reserve, asked the Congress for a new
program aimed at stabilizing our financial markets. The resulting legislation, the Emergency
Economic Stabilization Act, provides important new tools for addressing the distress in
financial markets and thus mitigating the risks to the economy. The act allows Treasury to
buy troubled assets, to provide guarantees, and to inject capital to strengthen the balance
sheets of financial institutions. The act also raises the limit on deposit insurance from
$100,000 to $250,000 per account, effectively immediately.
The Troubled Asset Relief Program (TARP) authorized by the legislation will allow the
Treasury, under the supervision of an oversight board that I will head, to undertake two
highly complementary activities. First, the Treasury will use the TARP funds to help
recapitalize our banking system by purchasing non-voting equity in financial institutions.
Details of this program were announced yesterday. Initially, the Treasury will dedicate $250
billion toward purchases of preferred shares in banks and thrifts of all sizes. The program is
voluntary and designed both to encourage participation by healthy institutions and to make it
attractive for private capital to come in along with public capital. We look to strong institutions
to participate in this capital program, because today even strong institutions are reluctant to
expand their balance sheets to extend credit; with fresh capital, that constraint will be eased.
The terms offered under the TARP include the acquisition by the Treasury of warrants to
ensure that taxpayers receive a share of the upside as the financial system recovers.
Moreover, as required by the legislation, institutions that receive capital will have to meet
certain standards regarding executive compensation practices.
Second, the Treasury will use some of the resources provided under the bill to purchase
troubled assets from banks and other financial institutions, in most cases using market-based
mechanisms. Mortgage-related assets, including mortgage-backed securities and whole
loans, will be the focus of the program, although the law permits flexibility in the types of
assets purchased as needed to promote financial stability. Removing these assets from
private balance sheets should increase liquidity and promote price discovery in the markets
for these assets, thereby reducing investor uncertainty about the current value and prospects
of financial institutions. Unclogging the markets for mortgage-related assets should put banks
and other institutions in a better position to raise capital from the private sector and increase
the willingness of counterparties to engage. With time, the provision of equity capital to the
banking system and the purchase of troubled assets will help credit flow more freely, thus
supporting economic growth.
These measures will lead to a much stronger financial system over time, but steps are also
necessary to address the immediate problem of lack of trust and confidence. Accordingly,
also announced yesterday was a plan by the Federal Deposit Insurance Corporation (FDIC)
to provide a broad range of guarantees of the liabilities of FDIC-insured depository
institutions, including their associated holding companies. The guarantee covers all newly
issued senior unsecured debt, including commercial paper and interbank funding, and it will
also cover all funds held in non-interest-bearing transactions accounts, such as payroll
accounts. This broad guarantee will be effectively immediately, and fees for coverage will be
waived for 30 days. After the 30-day grace period, banks may continue to participate in the
guarantee program by paying reasonable fees.
I would like to stress once again that the taxpayers' interests were very much in our minds
and those of the Congress when these programs were designed. The costs of the FDIC
guarantee are expected to be covered by fees and assessments on the banking system, not
by the taxpayer. In the case of the TARP program, the funds allocated are not simple
expenditures, but rather acquisitions of assets or equity positions, which the Treasury will be
able to sell or redeem down the road. Indeed, it is possible that taxpayers could turn a profit
from the program, although, given the great uncertainties, no assurances can be provided.
Moreover, the program is subject to extensive controls and to oversight by several bodies.
The larger point, though, is that the economic benefit of these programs to taxpayers will not
be determined primarily by the financial return to TARP funds, but rather by the impact of the
program on the financial markets and the economy. If the TARP, together with the other
measures that have been taken, is successful in promoting financial stability and,
consequently, in supporting stronger economic growth and job creation, it will have proved
itself a very good investment indeed, to everyone's benefit.
Stabilization of the financial markets is a critical first step, but even if they stabilize as we
hope they will, broader economic recovery will not happen right away. Economic activity had
been decelerating even before the recent intensification of the crisis. The housing market
continues to be a primary source of weakness in the real economy as well as in the financial
markets, and we have seen marked slowdowns in consumer spending, business investment,
and the labor market. Credit markets will take some time to unfreeze. And with the
economies of our trading partners slowing, our export sales, which have been a source of
strength, very probably will slow as well. These restraining influences on economic activity,
however, will be offset somewhat by the favorable effects of lower prices for oil and other
commodities on household purchasing power. Ultimately, the trajectory of economic activity
beyond the next few quarters will depend greatly on the extent to which financial and credit
markets return to more normal functioning.
Inflation has been elevated recently, reflecting the steep increases in the prices of oil, other
commodities, and imports that occurred earlier this year, as well as some pass-through by
firms of their higher costs of production. However, expected inflation, as measured by
consumer surveys and inflation-indexed Treasury securities, has held steady or eased, and
prices of imports now appear to be decelerating. These developments, together with the
recent declines in prices of oil and other commodities as well as the likelihood that economic
activity will fall short of potential for a time, should lead to rates of inflation more consistent
with price stability.
This past weekend, the finance ministers and central bank governors of the Group of Seven
industrialized countries met in Washington. We committed to work together to stabilize
financial markets and restore the flow of credit to support global economic growth. We
agreed to use all available tools to prevent failures that pose systemic risk. We affirmed we
will ensure our deposit insurance programs instill confidence in the safety of savings. We
agreed to ensure that our banks and other major financial intermediaries, as needed, can
raise capital from public as well as private sources. We further agreed that we would take all
necessary steps to unfreeze interbank and money markets, and that we will act to restart the
secondary markets for mortgages and other securitized assets. Finally, we recognized that
we should take these actions in ways that protect taxpayers and avoid potentially damaging
effects on other countries. I believe that these are the right principles for action, and I see the
steps announced by our government yesterday as fully consistent with them.
I have laid out for you today an extraordinary series of actions taken by policymakers
throughout our government and around the globe. Americans can be confident that every
resource is being brought to bear to address the current crisis: historical understanding,
technical expertise, economic analysis, financial insight, and political leadership. I am not
suggesting the way forward will be easy, but I strongly believe that we now have the tools we
need to respond with the necessary force to these challenges. Although much work remains
and more difficulties surely lie ahead, I remain confident that the American economy, with its
great intrinsic vitality and aided by the measures now available, will emerge from this period
with renewed vigor.