William C Dudley: More lessons from the crisis
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Center for Economic Policy Studies (CEPS) Symposium,
Princeton, New Jersey, 13 November 2009.
* * *
Thank you for having me here to speak today. It is a real pleasure to have this opportunity to
speak at CEPS again - this is a great forum to talk about policy issues. Tonight I want to
discuss some of the challenges we face in making our financial system more robust. We
have learned a great deal over the past two years about our financial system and its
vulnerabilities. The task ahead is to put these lessons to good use. Our goal must be to
make the financial system more resilient to shocks. If we can do that successfully, we should
be able to reduce the risk of financial crises.
In assessing the causes of this crisis, one clear culprit was the failure of regulators and
market participants alike to fully appreciate the strength of the amplifying mechanisms that
were built into our financial system. These mechanics exacerbated the boom on the way up
and the bust on the way down. Only by better understanding the sources of these damaging
dynamics can we construct solutions that will strengthen our financial system and make it
more robust.
Today, I am going to focus mainly on the extraordinary liquidity events that played out during
this crisis. I will tackle this topic in four parts. I will begin by describing how funding dried up
rapidly for firms such as Bear Stearns, Lehman Brothers, and AIG. I then will propose a
conceptual framework that might prove helpful in better understanding what went wrong on
the liquidity front. With this conceptual framework in hand, I will then suggest some concrete
steps we might take toward making the financial system more resilient - cautioning that there
are no magic bullets. Finally, I will talk about the major initiatives that are already underway
to help reduce the risk of future liquidity crises.
As always, my remarks reflect my own views and opinions and not necessarily those of the
Federal Reserve System.
At its most fundamental level, this crisis was caused by the rapid growth of the so-called
shadow banking system over the past few decades and its remarkable collapse over the past
two years. Let me give you some figures to illustrate the disparity between the growth of what
I will call the "traditional" commercial banking system and the shadow banking system in
recent years. At the end of 2006, the shadow banking system had grown so large that U.S.
commercial banks' share of credit market assets had fallen to only 17.7 percent, down from
27.3 percent in 1980.
With this shift in the composition of activity also came an important change in the
composition of funding, particularly in the middle part of this decade. Commercial paper
outstanding grew from $1.3 trillion at the end of 2003 to a peak of about $2.3 trillion. Repo
funding by dealers to nonbank financial institutions - as measured by the reverse repos on
primary dealer balance sheets - grew from less than $1.3 trillion to a peak of nearly $2.8
trillion over this period. In contrast, commercial bank retail deposits rose by less than 30% in
the four year period from 2003 to 2007.
Though the shadow banking system was often credited with better distributing risk and
improving the overall efficiency of the financial system, this system ultimately proved to be
much more fragile than we had anticipated. Like the traditional banking system, the shadow
banking system engaged in the maturity transformation process in which structured
investment vehicles (SIVs), conduits, dealers, and hedge funds financed long-term assets
with short-term funding. However, much of the maturity transformation in the shadow system
occurred without the types of stabilizing backstops that are in place in the traditional banking
sector.
A key vulnerability turned out to be the misplaced assumption that securities dealers and
others would be able to obtain very large amounts of short-term funding even in times of
stress. Indeed, one particularly destabilizing factor in this collapse was the speed with which
liquidity buffers at the large independent security dealers were exhausted. To take just one
illustrative example, Bear Stearns saw a complete loss of its short-term secured funding
virtually overnight. As a consequence, the firm's liquidity pool dropped by 83 percent in a
two-day span.1
These liquidity dynamics were driven by two main factors. The first factor was the underlying
stress on dealer balance sheets as the prices on complex collateralized debt obligations
(CDOs), private label residential mortgage-backed securities (RMBS), and commercial real
estate-related assets fell sharply and uncertainty about underlying asset values rose sharply.
The uncertainty stemmed, in part, from the lack of transparency about what prices these
assets could be sold for, which, in turn stemmed from the difficulty of valuing these extremely
complex and heterogeneous securities.
The stress on underlying asset prices and the uncertainty about the valuations of pools of
illiquid assets caused investors to become concerned about the solvency of some of the
weaker dealers.2 These concerns contributed to liquidity pressures, which, in turn, led to
forced asset sales by dealers and others. These sales both further depressed asset prices
and increased asset price volatility.
The second factor contributing to the liquidity crisis was the dependence of dealers on
shortterm funding to finance illiquid assets. This short-term funding came mainly from two
sources, the tri-party repo system and customer balances in prime brokerage accounts. By
relying on these sources of funding, dealers were much more vulnerable to runs than was
generally appreciated.
Consider first tri-party repo, a market in which money market funds, securities lending
operations, and other institutions finance assets mainly on an overnight basis. As asset
prices fell and volatility climbed during this period, the financial condition of some dealers
became more troubled. As a result, some investors in this market became worried about the
risk that they might not get their cash returned in the morning, but instead might be stuck with
the collateral that secured their lending. Investors responded by increasing their haircuts -
that is the margin of extra collateral used to secure their funding - and reducing the range of
collateral they would accept as security for their lending. Of course, these very rational
reactions on the part of investors only further weakened the liquidity positions of the major
securities firms.
A similar dynamic occurred in the context of prime brokerage accounts. Some institutions
treated the free cash balances associated with these accounts as if they were a stable
source of funding. Implicitly, they assumed that these balances would be "sticky" due to the
strength of broader business relationships and the cost incurred by customers in shifting the
business elsewhere. However, once markets became strained, this assumption of stable
funding proved to be false. Prime brokerage customers began to withdraw their free credit
balances and some moved their business elsewhere. Both of these steps reduced dealer
liquidity buffers and further tightened the funding noose.
In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the
design of the underlying market infrastructure. In this market, investors provide cash each
afternoon to dealers in the form of an overnight loan backed by securities collateral.
Each morning, under normal circumstances, the two clearing banks that operate tri-party
repo systems permit dealers to return the cash to their investors and to retake possession of
their securities portfolios by overdrawing their accounts at the clearing banks. During the day,
the clearing banks finance the dealers' securities inventories.
Usually, this arrangement works well. However, when a securities dealer becomes troubled
or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if
there is a material risk that a dealer could default during the day, the clearing bank may not
want to return the cash to the tri-party investors in the morning because the bank does not
want to risk being stuck with a very large collateralized exposure that could run into the
hundreds of billions of dollars. Overnight investors, in turn, don't want to be stuck with the
collateral. So to avoid such an outcome, they may decide not to invest in the first place.
These self-protective reactions on the part of the clearing banks and the investors can cause
the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with
which Bear Stearns lost funding as tri-party repo investors pulled away quickly.
Despite the strains created by the collapse of Bear Stearns, the "rivets" of the tri-party repo
system held for several reasons. First, Bear Sterns did not fail; instead it was acquired by
JPMorgan Chase with assistance from the Federal Reserve. Second, the Federal Reserve
stepped in to support the tri-party repo system by implementing the Primary Dealer Credit
Facility (PDCF). The PDCF essentially placed the Fed in the role of the tri-party repo investor
of last resort thereby significantly reducing the risk to the clearing banks that they might be
stuck with the collateral. As a consequence, the PDCF reassured end investors that they
could safely keep investing. This, in turn, significantly reduced the risk that a dealer would
not be able to obtain short-term funding through the tri-party repo system.3
Over much of this period preceding the failure of Lehman Brothers, U.S. commercial banks
were relatively insulated from the liquidity run dynamics that plagued the securities dealers.4
This relative stability was due, in part, to the broad access these commercial banks had to
the Fed's discount window through the traditional primary credit facility and through the Term
Auction Facility (TAF), which had been introduced earlier in the crisis in response to liquidity
strains in the interbank market. The fact that most commercial banks relied on insured
deposits for significant portions of their funding was also important. Not only were these
insured deposits stable sources of funding because they were guaranteed by the Federal
Deposit Insurance Corporation (FDIC), but also because they were unsecured; these
deposits freed up collateral that could be used by banks to secure borrowing from the central
bank and elsewhere.
However, once Lehman Brothers failed, many commercial banks and other financial
institutions encountered significant funding difficulties. News that the Reserve Fund - a large
money market mutual fund - had "broken the buck" due to its holdings of Lehman Brothers
paper led panicked investors to withdraw their funds from money market mutual funds. This
caused the commercial paper market to virtually shut down. This hurt bank holding
companies and other large financial firms that depended on the commercial paper market for
short-term funding.
The result was a widespread loss of confidence throughout the money market and interbank
funding market. Investors became unwilling to lend even to institutions that they perceived to
be solvent because of worries that others might not share the same opinion. Rollover risk -
the risk that an investor's funds might not be repaid in a timely way - became extremely high.
The extreme market illiquidity did not abate until a number of extraordinary actions were
taken by the Federal Reserve and others. For example, the Federal Reserve introduced the
Commercial Paper Funding Facility (CPFF) to reduce rollover risk in the commercial paper
market, the Federal Reserve and other central banks' massively expanded the ability of
banks to obtain dollar funding through the TAF and associated foreign exchange swap
programs; the Treasury guaranteed money market mutual fund assets; and the FDIC
increased deposit insurance limits and set up the Temporary Liquidity Guarantee Program
(TLPG) to backstop bank and bank holding company debt issuance.
Having described "what" happened on the liquidity front during the crisis, I next want to
examine, in a bit more detail, "why" it happened. To do this, I will lay out a simple conceptual
framework that I will then use to assess what can be done to mitigate the risk of such runs
occurring in the future. As a starting point, I will talk about how unsecured lenders react in a
crisis, and then I will consider the behavior of secured lenders.
Unsecured liquidity providers run for two basic reasons. First, they run because there is a
risk that the company they are lending funds to is insolvent. In other words, there is a risk
that the assets will be worth less than the liabilities, creating the potential for loss to the
creditor. The second reason that unsecured creditors run is the risk that they will not be
repaid in a timely way. Even if the borrowing firm ultimately turns out to be solvent, there may
be a delay in a lender getting its funds back, and this delay may prove to be unacceptably
costly to the lender.
This second cause of liquidity runs - the risk of untimely repayment - is significant because it
means that expectations about the behavior of others, or their "psychology", can be
important. This is a classic coordination problem. Even if a particular lender judges a firm to
be solvent, it might decide not to lend to that firm for fear that others might not share the
same assessment. The less certain any one lender is about the willingness of other lenders
to provide liquidity to a firm, the greater the risk that too few loans will be extended to prevent
liquidation. In that case, even if the lender turns out to be correct in its judgment of the firm's
solvency, there still will be a cost in terms of delay in receiving repayment.
A few pictures can help to illustrate these concepts. Figure 1 illustrates what a creditor's
assessment of the net worth of a financial firm might look like in normal times. Creditors have
uncertainty about what that value is, thus, the valuation is represented by a probability
distribution. The higher the degree of uncertainty, the greater is the degree of dispersion in
the probability distribution. As long as the probability distribution is sufficiently far to the right
- in other words - well within positive territory so that there is virtually no risk that the firm is
insolvent, lenders will generally be willing to lend.
So what happens in a financial crisis? First, the probability distribution shifts to the left as the
financial environment deteriorates and the financial firm takes losses that deplete its capital.
Second, and even more importantly, the dispersion of the probability distribution widens -
lenders become more uncertain about the value of the firm. These two phenomena are
shown together in Figure 2. A lack of transparency in the underlying assets will exacerbate
this increase in dispersion. As the degree of dispersion widens, a portion of the probability
distribution falls into negative territory. This means that there is a real risk of loss for
unsecured creditors if the firm were forced to liquidate its assets.
Finally, in a crisis, unsecured lenders become more uncertain about others' assessment of
the probability distribution. For example, if creditor A believes the probability distribution
looks like Figure 1, but at the same time is concerned that creditor B views the probability
distribution as looking like Figure 2, creditor A may pull back. If there is a risk creditor B and
others will not lend, the firm may not receive sufficient funding. In other words, even if
creditor A believes the firm is solvent, it may not lend because it does not want to risk a delay
in repayment.
So what can creditors do to mitigate these risks? First, they can respond by charging a
higher interest rate in compensation for the increase in the risk of default. However, there are
a number of difficulties that limit how well this works in practice. Most significantly, by
undermining the firm's profitability, the higher interest rates may increase the risk of
insolvency. If higher rates push insolvency risk up sharply, then higher rates may not be
sufficient to make lending - even at higher rates - an attractive proposition.
In addition, some investors such as money market mutual funds may have a very low
tolerance for risk. Thus, they may not be interested in trading off higher rates as
compensation for a non-negligible increase in insolvency risk. Finally, paying higher rates
may generate an adverse signal about the health of the borrowing institution. This may cause
investors to become more worried about the risk of default.
Second, creditors can secure their lending - taking collateral valued at more than the amount
they lend. However, this is not foolproof because secured funding can be just as vulnerable
to a run dynamic as unsecured funding. For starters, the same types of uncertainties about
the value of the firm may apply to the liquidation value of the collateral. This is especially the
case if the collateral is lower quality and markets are already illiquid. Moreover, if creditors
are left with the collateral instead of being repaid, fear of widespread collateral liquidation
might further erode collateral values. If investors respond by seeking more collateral to
ensure they will be secured - that is, that they will be made whole in a liquidation scenario -
the firm may run out of high-quality collateral that the firm can borrow against. This is a
significant risk when a financial firm is highly leveraged and equity is only a very small
proportion of total assets.5
The risks of liquidity crises are also exacerbated by some structural sources of instability in
the financial system. Some of these sources are endemic to the nature of the financial
intermediation process and banking. Others are more specific to the idiosyncratic features of
our particular system. Both types deserve attention because they tend to amplify the
pressures that lead to liquidity runs.
Turning first to the more inherent sources of instability, there are at least two that are worthy
of mention. The first instability stems from the fact that most financial firms engage in
maturity transformation - the maturity of their assets is longer than the maturity of their
liabilities. The need for maturity transformation arises from the fact that the preferred habitat
of borrowers tends toward longer-term maturities used to finance long-lived assets such as a
house or a manufacturing plant, compared with the preferred habitat of investors, who
generally have a preference to be able to access their funds quickly. Financial intermediaries
act to span these preferences, earning profits by engaging in maturity transformation -
borrowing shorter-term in order to finance longer-term lending.
If a firm engages in maturity transformation so that its assets mature more slowly than its
liabilities, it does not have the option of simply allowing its assets to mature when funding
dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened.
Maturity transformation means that if funding is not forthcoming, the firm will have to sell
assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets
are lower quality. In that case, the forced asset sales are likely to lead to losses, which
deplete capital and raise concerns about insolvency.6
The second inherent source of instability stems from the fact that firms are typically worth
much more as going concerns than in liquidation. This loss of value in liquidation helps to
explain why liquidity crises can happen so suddenly. Initially, no one is worried about
liquidation. The firm is well understood to be solvent as shown in Figure 1. But once
counterparties start to worry about liquidation, the probability distribution can shift very
quickly toward the insolvency line, as shown in Figure 2, because the liquidation value is
lower than the firm's value as a going concern.
There are also a number of idiosyncratic sources of instability worthy of mention, some of
which are unique to our particular system. One source of instability is the tri-party repo
system that I discussed earlier. Another is the convention of tying collateral calls to credit
ratings. In this case, if a firm's credit rating is lowered, the firm may have to post additional
collateral to its counterparties, eliminating this collateral as a potential source of funding. This
phenomenon was a particularly important problem for AIG, which lost its access to the
commercial paper market and was subject to increased collateral calls. Both factors caused
the liquidity of the AIG parent company to be depleted very quickly. Finally, if asset volatility
rises, haircuts can increase. This can lead to haircut spirals in which higher haircuts lead to
forced asset sales, increased volatility and still higher haircuts.
These sources of instability create the risk of a cascade - of firms moving rapidly from the
situation represented in Figure 1 to that shown in Figure 2. Once the firm's viability is in
question and it is does not have access to an insured deposit funding base, the next stop is
often a full-scale liquidity crisis that often cannot be stopped without massive government
intervention.
Fortunately, there are ways to mitigate the risk of a cascade. First, we can require that
financial intermediaries hold more capital. This would push the probability distribution to the
right in Figure 2. With sufficient additional capital, the probability of insolvency could be
reduced to a low enough level that liquidity providers would not run.
Higher capital requirements work to reduce the risk of liquidity runs, but potentially at the cost
of making the process of financial intermediation much more expensive. In particular, a
requirement that firms must hold more capital increases intermediation costs. Moreover,
banks may respond to higher capital requirements by taking on greater risk. If an increase in
risk-taking were to occur, the movement of the probability distribution to the right in Figure 2
might be offset by an increase in the degree of dispersion. Thus, higher capital requirements
might not necessarily be sufficient to push all of the probability distribution above zero.
Second, regulators could require greater liquidity buffers. These buffers would help protect
the firm against having to liquidate assets under duress, and would therefore help prevent
the probability distribution from sliding left toward the zero line in Figure 2. But there is a cost
to the firm from holding greater liquidity buffers in terms of lower returns on capital. So,
requiring greater liquidity buffers would also tend to drive up intermediation costs. And, just
as in the case of higher capital requirements, banks could respond by taking greater risks.
Third, regulators could implement changes that would reduce the degree of dispersion in the
potential value of a firm, pushing the right tail of the distribution in Figure 2 to the left. For
example, we could require greater transparency about the composition and quality of the
firm's assets and liabilities. Or, regulators could increase transparency by forcing greater
disclosure of the sale price of assets and/or by pushing for greater homogeneity and price
discovery for products such as OTC derivatives. We could improve the quality of regulation
and supervision, which would increase confidence in regulatory measures of capital and
financial firms' soundness.
Fourth, the central bank could provide a liquidity backstop to solvent firms. For example, the
central bank could commit to being the lender of last resort as long as it judged the firm to be
solvent and with sufficient collateral. This would reduce the coordination problem and the risk
of panics sparked by uncertainty among lenders about what other creditors think. If the
central bank is willing to provide backstop liquidity, then a lender that judges the financial firm
to be solvent should be willing to lend. The backstop liquidity ensures timely repayment. The
lender of last resort role eliminates the externality in which the expectations about the
willingness of one lender to lend influences the decisions of others.
However, providing a liquidity backstop is not without its own set of problems. If firms have
liquidity backstops that are viewed as credible, then this creates moral hazard. Firms do not
have to worry as much about what lenders think about their capital adequacy or the size of
their liquidity buffers. This creates incentives to run leaner in terms of capital and liquidity,
which increases the risks to the backstop liquidity provider.
To mitigate such effects, the backstop liquidity provider could presumably charge financial
firms for the value of the backstop. But what fee would be appropriate? It is difficult to assess
the probability of financial panics and the value of backstop liquidity facilities.7
Fifth, regulators could take steps to reduce the difference between the value of the firm dead
versus alive. For example, we could improve the resolution process so that less of a firm's
value is destroyed by the liquidation process. If we could reduce the difference in value
between a firm as a going concern versus the same firm in liquidation we could reduce the
severity of the cascade effect when financial conditions deteriorate.
Sixth, we could make structural changes to the financial system to make it more stable in
terms of liquidity provision. For example, consider the three structural issues outlined earlier
that amplified the crisis - tri-party repo, collateral requirements tied to credit ratings, and
haircut spirals. In the case of tri-party repo, the amplifying dynamics could be reduced by
enforcing standards that limited the scope of eligible collateral or required more conservative
haircuts. Formal loss-sharing arrangements among tri-party repo borrowers, investors, and
clearing banks might reduce or eliminate any advantage that might stem from running early.
Eliminating the market's reliance on intraday credit provided by clearing banks could
eliminate the tension between the interests of clearing banks and investors when a dealer
becomes troubled. In the case of collateral requirements, collateral haircuts could be
required to be independent of ratings.
Many of these suggestions are already in the process of being implemented. For example,
the Basel Committee is in the process of strengthening bank capital in four ways: 1) higher
capital requirements; 2) higher quality capital; 3) more complete risk capture; and 4) capital
conservation measures, including the use of contingent capital instruments. With greater
capital buffers, the risk of liquidity runs should be reduced going forward. It should be noted,
however, that use of contingent capital instruments, or any other potential changes to our
current capital regime, does not obviate the need for an improved resolution process.
Second, the Basel Committee is moving forward with its work in establishing liquidity
standards for large, complex financial institutions. These liquidity standards would consist of
two parts. First, there would be a liquidity buffer made up of high-quality liquid assets that
would be of sufficient size so that the firm could manage a stress event caused by a
shortterm loss of investor confidence. Second, there would be rules concerning the degree of
allowable maturity transformation. Long-term illiquid assets would have to be largely funded
by equity and longer-term borrowing, not by short-term borrowing, such as tri-party repo.
Third, the Federal Reserve is working with a broad range of private sector participants,
including dealers, clearing banks, and tri-party repo investors to eliminate the structural
instability of the tri-party repo system so that tri-party borrowers are less vulnerable to runs.
Exactly how the mechanics of the tri-party repo system will be adjusted is still a work in
process.8
Fourth, the major U.S. securities dealers are now subject to supervision by the Federal
Reserve under the Bank Holding Company Act. This means that their liquidity funding needs
are subject to supervisory oversight, including stress tests, to ensure that the firms can meet
large funding drains.
Liquidity risk will never be eliminated, nor should it. The preferences of borrowers to borrow
long and of lenders to lend short means that the maturity transformation process generates
real benefits. However, we can do better to make our system less prone to the types of
liquidity runs that we have experienced. If we remain committed to implementing the reforms
that are already underway, I am confident that we can dramatically reduce the risks of the
type of liquidity crises that we experienced all too recently.
Thank you for your kind attention. I would be happy to take a few questions.
BIS Review 143/2009