Ben S Bernanke: The crisis as a classic financial panic
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Fourteenth Jacques Polak Annual Research Conference,
Washington DC, 8 November 2013.
* * *
I am very pleased to participate in this event in honor of Stanley Fischer. Stan was my
teacher in graduate school, and he has been both a role model and a frequent adviser ever
since. An expert on financial crises, Stan has written prolifically on the subject and has also
served on the front lines, so to speak - notably, in his role as the first deputy managing
director of the International Monetary Fund during the emerging market crises of the 1990s.
Stan also helped to fight hyperinflation in Israel in the 1980s and, as the governor of that
nation's central bank, deftly managed monetary policy to mitigate the effects of the recent
crisis on the Israeli economy. Subsequently, as Israeli housing prices ran upward, Stan
became an advocate and early adopter of macroprudential policies to preserve financial
stability.
Stan frequently counseled his students to take a historical perspective, which is good advice
in general, but particularly helpful for understanding financial crises, which have been around
a very long time. Indeed, as I have noted elsewhere, I think the recent global crisis is best
understood as a classic financial panic transposed into the novel institutional context of the
21st century financial system.1 An appreciation of the parallels between recent and historical
events greatly influenced how I and many of my colleagues around the world responded to
the crisis.
Besides being the fifth anniversary of the most intense phase of the recent crisis, this year
also marks the centennial of the founding of the Federal Reserve.2 It's particularly
appropriate to recall, therefore, that the Federal Reserve was itself created in response to a
severe financial panic, the Panic of 1907. This panic led to the creation of the National
Monetary Commission, whose 1911 report was a major impetus to the Federal Reserve Act,
signed into law by President Woodrow Wilson on December 23, 1913. Because the Panic of
1907 fit the archetype of a classic financial panic in many ways, it's worth discussing its
similarities and differences with the recent crisis.3
Like many other financial panics, including the most recent one, the Panic of 1907 took place
while the economy was weakening; according to the National Bureau of Economic Research,
a recession had begun in May 1907.4 Also, as was characteristic of pre-Federal Reserve
1
See Ben S. Bernanke (2012), "Some Reflections on the Crisis and the Policy Response," speech delivered at
"Rethinking Finance," a conference sponsored by the Russell Sage Foundation and Century Foundation, New
York, April 13. For the classic discussion of financial panics and the appropriate central bank response, see
Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York: Charles
Scribner's Sons).
2
Information on the centennial of the Federal Reserve System is available at www.federalreserve.gov/
aboutthefed/centennial/about.htm.
3
The Panic of 1907 is discussed in a number of sources, including O.M.W. Sprague (1910), A History of Crises
under the National Banking System (PDF), National Monetary Commission (Washington: U.S. Government
Printing Office), and, with a focus on its monetary consequences, Milton Friedman and Anna Jacobson
Schwartz (1963), A Monetary History of the United States, 1867-1960 (Princeton, N.J.: Princeton University
Press). An accessible discussion of the episode, from which this speech draws heavily, can be found in
Jon R. Moen and Ellis W. Tallman (1990), "Lessons from the Panic of 1907 (PDF)," Federal Reserve Bank of
Atlanta, Economic Review, May/June, pp. 2-13.
4
See Charles W. Calomiris and Gary Gorton (1991), "The Origins of Banking Panics: Models, Facts, and Bank
Financial Markets and Financial Crises
Regulation," in R. Glenn Hubbard, ed., (Chicago: University of Chicago
Press), pp. 109-74.
panics, money markets were tight when the panic struck in October, reflecting the strong
seasonal demand for credit associated with the harvesting and shipment of crops. The
immediate trigger of the panic was a failed effort by a group of speculators to corner the
stock of the United Copper Company. The main perpetrators of the failed scheme,
F. Augustus Heinze and C.F. Morse, had extensive connections with a number of leading
financial institutions in New York City. When the news of the failed speculation broke,
depositor fears about the health of those institutions led to a series of runs on banks,
including a bank at which Heinze served as president. To try to restore confidence, the New
York Clearinghouse, a private consortium of banks, reviewed the books of the banks under
pressure, declared them solvent, and offered conditional support - one of the conditions
being that Heinze and his board step down. These steps were largely successful in stopping
runs on the New York banks.
But even as the banks stabilized, concerns intensified about the financial health of a number
of so-called trust companies - financial institutions that were less heavily regulated than
national or state banks and which were not members of the Clearinghouse. As the runs on
the trust companies worsened, the companies needed cash to meet the demand for
withdrawals. In the absence of a central bank, New York's leading financiers, led by
J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided
that they did not have sufficient information to judge the solvency of the affected institutions,
so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on
October 22, undermining public confidence in the remaining trust companies.
To satisfy their depositors' demands for cash, the trust companies began to sell or liquidate
assets, including loans made to finance stock purchases. The selloff of shares and other
assets, in what today we would call a fire sale, precipitated a sharp decline in the stock
market and widespread disruptions in other financial markets. Increasingly concerned,
Morgan and other financiers (including the future governor of the Federal Reserve Bank of
New York, Benjamin Strong) led a coordinated response that included the provision of
liquidity through the Clearinghouse and the imposition of temporary limits on depositor
withdrawals, including withdrawals by correspondent banks in the interior of the country.
These efforts eventually calmed the panic. By then, however, the U.S. financial system had
been severely disrupted, and the economy contracted through the middle of 1908.
The recent crisis echoed many aspects of the 1907 panic. Like most crises, the recent
episode had an identifiable trigger - in this case, the growing realization by market
participants that subprime mortgages and certain other credits were seriously deficient in
their underwriting and disclosures. As the economy slowed and housing prices declined,
diverse financial institutions, including many of the largest and most internationally active
firms, suffered credit losses that were clearly large but also hard for outsiders to assess.
Pervasive uncertainty about the size and incidence of losses in turn led to sharp withdrawals
of short-term funding from a wide range of institutions; these funding pressures precipitated
fire sales, which contributed to sharp declines in asset prices and further losses. Institutional
changes over the past century were reflected in differences in the types of funding that ran:
In 1907, in the absence of deposit insurance, retail deposits were much more prone to run,
whereas in 2008, most withdrawals were of uninsured wholesale funding, in the form of
commercial paper, repurchase agreements, and securities lending. Interestingly, a steep
decline in interbank lending, a form of wholesale funding, was important in both episodes.
Also interesting is that the 1907 panic involved institutions - the trust companies - that faced
relatively less regulation, which probably contributed to their rapid growth in the years leading
up to the panic. In analogous fashion, in the recent crisis, much of the panic occurred outside
the perimeter of traditional bank regulation, in the so-called shadow banking sector.5
The responses to the panics of 1907 and 2008 also provide instructive comparisons. In both
cases, the provision of liquidity in the early stages was crucial. In 1907 the United States had
no central bank, so the availability of liquidity depended on the discretion of firms and private
individuals, like Morgan. In the more recent crisis, the Federal Reserve fulfilled the role of
liquidity provider, consistent with the classic prescriptions of Walter Bagehot.6 The Fed lent
not only to banks, but, seeking to stem the panic in wholesale funding markets, it also
extended its lender-of-last-resort facilities to support nonbank institutions, such as investment
banks and money market funds, and key financial markets, such as those for commercial
paper and asset-backed securities.
In both episodes, though, liquidity provision was only the first step. Full stabilization requires
the restoration of public confidence. Three basic tools for restoring confidence are temporary
public or private guarantees, measures to strengthen financial institutions' balance sheets,
and public disclosure of the conditions of financial firms. At least to some extent, Morgan and
the New York Clearinghouse used these tools in 1907, giving assistance to troubled firms
and providing assurances to the public about the conditions of individual banks. All three
tools were used extensively in the recent crisis: In the United States, guarantees included the
Federal Deposit Insurance Corporation's (FDIC) guarantees of bank debt, the Treasury
Department's guarantee of money market funds, and the private guarantees offered by
stronger firms that acquired weaker ones. Public and private capital injections strengthened
bank balance sheets. Finally, the bank stress tests that the Federal Reserve led in the spring
of 2009 and the publication of the stress-test findings helped restore confidence in the U.S.
banking system. Collectively, these measures helped end the acute phase of the financial
crisis, although, five years later, the economic consequences are still with us.
Once the fire is out, public attention turns to the question of how to better fireproof the
system. Here, the context and the responses differed between 1907 and the recent crisis. As
I mentioned, following the 1907 crisis, reform efforts led to the founding of the Federal
Reserve, which was charged both with helping to prevent panics and, by providing an "elastic
currency," with smoothing seasonal interest rate fluctuations. In contrast, reforms since 2008
have focused on critical regulatory gaps revealed by the crisis. Notably, oversight of the
shadow banking system is being strengthened through the designation, by the new Financial
Stability Oversight Council, of nonbank systemically important financial institutions (SIFIs) for
consolidated supervision by the Federal Reserve, and measures are being undertaken to
address the potential instability of wholesale funding, including reforms to money market
funds and the triparty repo market.7
As we try to make the financial system safer, we must inevitably confront the problem of
moral hazard. The actions taken by central banks and other authorities to stabilize a panic in
the short run can work against stability in the long run, if investors and firms infer from those
actions that they will never bear the full consequences of excessive risk-taking. As Stan
Fischer reminded us following the international crises of the late 1990s, the problem of moral
hazard has no perfect solution, but steps can be taken to limit it.8 First, regulatory and
supervisory reforms, such as higher capital and liquidity standards or restriction on certain
activities, can directly limit risk-taking. Second, through the use of appropriate carrots and
sticks, regulators can enlist the private sector in monitoring risk-taking. For example, the
Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) process, the
descendant of the bank stress tests of 2009, requires not only that large financial institutions
have sufficient capital to weather extreme shocks, but also that they demonstrate that their
internal risk-management systems are effective.9 In addition, the results of the stress-test
portion of CCAR are publicly disclosed, providing investors and analysts information they
need to assess banks' financial strength.
Of course, market discipline can only limit moral hazard to the extent that debt and equity
holders believe that, in the event of distress, they will bear costs. In the crisis, the absence of
an adequate resolution process for dealing with a failing SIFI left policymakers with only the
terrible choices of a bailout or allowing a potentially destabilizing collapse. The Dodd-Frank
Act, under the orderly liquidation authority in Title II, created an alternative resolution
mechanism for SIFIs that takes into account both the need, for moral hazard reasons, to
impose costs on the creditors of failing firms and the need to protect financial stability; the
FDIC, with the cooperation of the Federal Reserve, has been hard at work fleshing out this
authority.10 A credible resolution mechanism for systemically important firms will be important
for reducing uncertainty, enhancing market discipline, and reducing moral hazard.
Our continuing challenge is to make financial crises far less likely and, if they happen, far
less costly. The task is complicated by the reality that every financial panic has its own
unique features that depend on a particular historical context and the details of the
institutional setting. But, as Stan Fischer has done with unusual skill throughout his career,
one can, by stripping away the idiosyncratic aspects of individual crises, hope to reveal the
common elements. In 1907, no one had ever heard of an asset-backed security, and a single
private individual could command the resources needed to bail out the banking system; and
yet, fundamentally, the Panic of 1907 and the Panic of 2008 were instances of the same
phenomenon, as I have discussed today. The challenge for policymakers is to identify and
isolate the common factors of crises, thereby allowing us to prevent crises when possible
and to respond effectively when not.