Ben S Bernanke: Some reflections on the crisis and the policy response
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Russell Sage Foundation and The Century Foundation Conference on
"Rethinking Finance", New York, 13 April 2012.
* * *
I would like to thank the conference organizers for the opportunity to offer a few remarks on
the causes of the 2007-09 financial crisis as well as on the Federal Reserve's policy
response. The topic is a large one, and today I will be able only to lay out some basic
themes. In doing so, I will draw from talks and testimonies that I gave during the crisis and its
aftermath, particularly my testimony to the Financial Crisis Inquiry Commission in September
2010.1 Given the time available, I will focus narrowly on the financial crisis and the Federal
Reserve's response in its capacity as liquidity provider of last resort, leaving discussions of
monetary policy and the aftermath of the crisis to another occasion.
Triggers and vulnerabilities
In its analysis of the crisis, my testimony before the Financial Crisis Inquiry Commission drew
the distinction between triggers and vulnerabilities. The triggers of the crisis were the
particular events or factors that touched off the events of 2007-09 - the proximate causes, if
you will. Developments in the market for subprime mortgages were a prominent example of a
trigger of the crisis. In contrast, the vulnerabilities were the structural, and more fundamental,
weaknesses in the financial system and in regulation and supervision that served to
propagate and amplify the initial shocks. In the private sector, some key vulnerabilities
included high levels of leverage; excessive dependence on unstable short-term funding;
deficiencies in risk management in major financial firms; and the use of exotic and
nontransparent financial instruments that obscured concentrations of risk. In the public
sector, my list of vulnerabilities would include gaps in the regulatory structure that allowed
systemically important firms and markets to escape comprehensive supervision; failures of
supervisors to effectively apply some existing authorities; and insufficient attention to threats
to the stability of the system as a whole (that is, the lack of a macroprudential focus in
regulation and supervision).
The distinction between triggers and vulnerabilities is helpful in that it allows us to better
understand why the factors that are often cited as touching off the crisis seem
disproportionate to the magnitude of the financial and economic reaction. Consider subprime
mortgages, on which many popular accounts of the crisis focus. Contemporaneous data
indicated that the total quantity of subprime mortgages outstanding in 2007 was well less
than $1 trillion; some more-recent accounts place the figure somewhat higher. In absolute
terms, of course, the potential for losses on these loans was large - on the order of hundreds
of billions of dollars. However, judged in relation to the size of global financial markets,
aggregate exposures to subprime mortgages were quite modest. By way of comparison, it is
not especially uncommon for one day's paper losses in global stock markets to exceed the
losses on subprime mortgages suffered during the entire crisis, without obvious ill effect on
market functioning or on the economy. Thus, losses on subprime mortgages can plausibly
account for the massive reaction seen during the crisis only insofar as they interacted with
other factors - more fundamental vulnerabilities - that served to amplify their effects.
On the surface, the puzzle of disproportionate cause and effect seems somewhat less stark if
one takes the boom and bust in the U.S. housing market as the trigger of the crisis, as the
paper gains and losses associated with the swing in house prices were many times the
losses associated directly with subprime loans. Indeed, the 30 percent or so aggregate
decline in house prices since their peak has by now eliminated nearly $7 trillion in paper
wealth. However, on closer examination, it is not clear that even the large movements in
house prices, in the absence of the underlying weaknesses in our financial system, can
account for the magnitude of the crisis. First, much of the decline in house prices has
occurred since the most intense phase of the crisis; the decline in prices since September
2008 is probably better viewed as largely the result of, rather than a cause of, the crisis and
ensuing recession. More fundamentally, however, any theory of the crisis that ties its
magnitude to the size of the housing bust must also explain why the fall of dot-com stock
prices just a few years earlier, which destroyed as much or more paper wealth - more than
$8 trillion - resulted in a relatively short and mild recession and no major financial instability.2
Once again, the explanation of the differences between the two episodes must be that the
problems in housing and mortgage markets interacted with deeper vulnerabilities in the
financial system in ways that the dot-com bust did not. So let me turn, then, to a discussion
of those vulnerabilities and how they amplified the effects of triggers like the collapse of the
subprime mortgage market.
A number of the vulnerabilities I listed a few moments ago were associated with the
increased importance of the so-called shadow banking system. Shadow banking, as usually
defined, comprises a diverse set of institutions and markets that, collectively, carry out
traditional banking functions - but do so outside, or in ways only loosely linked to, the
traditional system of regulated depository institutions. Examples of important components of
the shadow banking system include securitization vehicles, asset-backed commercial paper
(ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos),
investment banks, and mortgage companies. Before the crisis, the shadow banking system
had come to play a major role in global finance.
Economically speaking, as I noted, shadow banking bears strong functional similarities to the
traditional banking sector. Like traditional banking, the shadow banking sector facilitates
maturity transformation (that is, it is used to fund longer-term, less-liquid assets with
short-term, more-liquid liabilities), and it channels savings into specific investments, mostly
debt-like instruments. In part, the rapid growth of shadow banking reflected various types of
regulatory arbitrage - for example, the minimization of capital requirements. However,
instruments that fund the shadow banking system, such as money market mutual funds and
repos, also met a rapidly growing demand among investors, generally large institutions and
corporations, seeking cash-like assets for use in managing their liquidity. Commercial banks
were limited in their ability to meet this growing demand by prohibitions on the payment of
interest on business checking accounts and by relatively low limits on the size of deposit
accounts that can be insured by the Federal Deposit Insurance Corporation (FDIC).
As became apparent during the crisis, a key vulnerability of the system was the heavy
reliance of the shadow banking sector, as well as some of the largest global banks, on
various forms of short-term wholesale funding, including commercial paper, repos, securities
lending transactions, and interbank loans. The ease, flexibility, and low perceived cost of
short-term funding also supported a broader trend toward higher leverage and greater
maturity mismatch in individual shadow banking institutions and in the sector as a whole.
While banks also rely on short-term funding and leverage, they benefit from a
government-provided safety net, including deposit insurance and backstop liquidity provision
by the central bank. Shadow banking activities do not have these safeguards, so they
employ alternative mechanisms to gain investor confidence. Among these mechanisms are
the collateralization of many shadow banking liabilities; regulatory or contractual restrictions
placed on portfolio holdings, such as the liquidity and credit quality requirements applicable
to money market mutual funds; and the imprimaturs of credit rating agencies. Indeed, the
very foundation of shadow banking and its rapid growth before the crisis was the widely held
view (among both investors and regulators) that these safeguards would protect shadow
banking activities against runs and panics, similar to the protection given to commercial
banking by the government safety net. Unfortunately, this view turned out to be wrong. When
it became clear to investors that these alternative protections might not be adequate to
protect against losses, widespread flight from the shadow banking system occurred, with
pernicious dynamics reminiscent of the banking panics of an earlier era.
Although the vulnerabilities associated with short-term wholesale funding and excessive
leverage can be seen as structural weaknesses of the global financial system, they can also
be viewed as a consequence of poor risk management by financial institutions and investors,
which I would count as another major vulnerability of the system before the crisis.
Unfortunately, the crisis revealed a number of significant defects in private-sector risk
management and risk controls, importantly including insufficient capacity by many large firms
to track firmwide risk exposures, such as off-balance-sheet exposures.
This lack of capacity by major financial institutions to track firmwide risk exposures led in turn
to inadequate risk diversification, so that losses - rather than being dispersed
broadly - proved in some cases to be heavily concentrated among relatively few, highly
leveraged companies. Here, I think, is the principal explanation of why the busts in dot-com
stock prices and in the housing and mortgage markets had such markedly different effects. In
the case of dot-com stocks, losses were spread relatively widely across many types of
investors. In contrast, following the housing and mortgage bust, losses were felt
disproportionately at key nodes of the financial system, notably highly leveraged banks,
broker-dealers, and securitization vehicles. Some of these entities were forced to engage in
rapid asset sales at fire-sale prices, which undermined confidence in counterparties exposed
to these assets, led to sharp withdrawals of funding, and disrupted financial intermediation,
with severe consequences for the economy.
Private-sector risk management also failed to keep up with financial innovation in many
cases. An important example is the extension of the traditional originate-to-distribute
business model to encompass increasingly complex securitized credit products, with
wholesale market funding playing a key role. In general, the originate-to-distribute model
breaks down the process of credit extension into components or stages - from origination to
financing and to the postfinancing monitoring of the borrower's ability to repay - in a manner
reminiscent of how manufacturers distribute the stages of production across firms and
locations. This general approach has been used in various forms for many years and can
produce significant benefits, including lower credit costs and increased access of consumers
and small and medium-sized businesses to capital markets. However, the expanded use of
this model to finance subprime mortgages through securitization was mismanaged at several
points, including the initial underwriting, which deteriorated markedly, in part because of
incentive schemes that effectively rewarded originators for the quantity rather than the quality
of the mortgages extended. Loans were then packaged into securities that proved complex,
opaque, and unwieldy; for example, when defaults became widespread, the legal
agreements underlying the securitizations made reasonable modifications of troubled
mortgages difficult. Rating agencies' ratings of asset-backed securities were revealed to be
subject to conflicts of interest and faulty models. At the end of the chain were investors who
often relied mainly on ratings and did not make distinctions among AAA-rated securities.
Even if the ultimate investors wanted to do their own credit analysis, the information needed
to do so was often difficult or impossible to obtain.
Dependence on short-term funding, high leverage, and inadequate risk management were
critical vulnerabilities of the private sector prior to the crisis. Derivative transactions further
increased risk concentrations and the vulnerability of the system, notably by shifting the
location and apparent nature of exposures in ways that were not transparent to many market
participants. But even as private-sector activities increased systemic risk, the public sector
also failed to appreciate or sufficiently respond to the building vulnerabilities in the financial
system - both because the statutory framework of financial regulation was not well suited to
addressing some key vulnerabilities and because some of the authorities that did exist were
not used effectively.
In retrospect, it is clear that the statutory framework of financial regulation in place before the
crisis contained serious gaps. Critically, shadow banking activities were, for the most part,
not subject to consistent and effective regulatory oversight. Much shadow banking lacked
meaningful prudential regulation, including various special purpose vehicles, ABCP conduits,
and many nonbank mortgage-origination companies. No regulatory body restricted the
leverage and liquidity policies of these entities, and few if any regulatory standards were
imposed on the quality of their risk management or the prudence of their risk-taking. Market
discipline, imposed by creditors and counterparties, helped on some dimensions but did not
effectively limit the systemic risks these entities posed.
Other shadow banking activities were potentially subject to some prudential oversight, but
weaknesses in the statutory and regulatory framework meant that in practice they were
inadequately regulated and supervised. For example, the Securities and Exchange
Commission supervised the largest broker-dealer holding companies but only through an
opt-in arrangement that lacked the force of a statutory regulatory regime. Large broker-dealer
holding companies faced serious losses and funding problems during the crisis, and the
instability of such firms as Bear Stearns and Lehman Brothers severely damaged the
financial system. Similarly, the insurance operations of American International Group, Inc.
(AIG), were supervised and regulated by various state and international insurance regulators,
and the Office of Thrift Supervision had authority to supervise AIG as a thrift holding
company. However, oversight of AIG Financial Products, which housed the derivatives
activities that imposed major losses on the firm, was extremely limited in practice.
The gaps in statutory authority had the additional effect of limiting the information available to
regulators and, consequently, may have made it more difficult to recognize the underlying
vulnerabilities and complex linkages in the overall financial system. Shadow banking
institutions that were unregulated or lightly regulated were typically not required to report
data that would have adequately revealed their risk positions or practices. Moreover, the lack
of preexisting reporting and supervisory relationships hindered systematic gathering of
information that might have helped policymakers in the early days of the crisis.
A broader failing was that regulatory agencies and supervisory practices were focused on the
safety and soundness of individual financial institutions or markets - what we now refer to as
microprudential supervision. In the United States and most other advanced economies, no
governmental entity had either a mandate or sufficient authority - now often called
macroprudential authority - to take actions to limit systemic risks that could result from the
collective behavior of financial institutions and markets.
Gaps in the statutory framework were an important reason for the buildup of risk in certain
parts of the system and for the inadequate response of the public sector to that buildup. But
even when the relevant statutory authorities did exist, they were not always used forcefully or
effectively enough by regulators and supervisors, including the Federal Reserve. Notably,
bank regulators did not do enough to force large financial institutions to strengthen their
internal risk-management systems or to curtail risky practices. The Federal Reserve's
Supervisory Capital Assessment Program, undertaken in the spring of 2009 and popularly
known as the "stress tests," played a critical role in restoring confidence in the U.S. banking
system, but it also demonstrated that many institutions' information systems could not
provide timely, accurate information about bank exposures to counterparties or complete
information about the aggregate risks posed by different positions and portfolios. Regulators
had recognized these problems in some cases but did not press firms vigorously enough to
fix them.
Even without a macroprudential mandate, regulators could also have done more to try to
mitigate risks to the broader financial system. In retrospect, stronger bank capital
standards - notably those relating to the quality of capital and the amount of capital required
for banks' trading book assets - and more attention to the liquidity risks faced by the largest,
most interconnected firms would have made the financial system as a whole more resilient.
The crisis as a classic financial panic
Having laid out some of the triggers and vulnerabilities that set the stage for the crisis, I can
briefly sketch the evolution of the crisis itself. As I have noted, developments in housing and
mortgage markets played an important role as triggers. Beginning in 2007, declining house
prices and rising rates of foreclosure raised serious concerns about the values of
mortgage-related assets and considerable uncertainty about where those losses would fall.
The economy officially fell into recession in December 2007, following several months of
financial stress. However, the most severe economic consequences followed the extreme
market movements in the fall of 2008.
To a significant extent, the crisis is best understood as a classic financial panic - differing in
details but fundamentally similar to the panics described by Bagehot and many others.3 The
most familiar type of panic that has occurred historically, involving runs on banks by retail
depositors, had been made largely obsolete by deposit insurance, central bank backstop
liquidity facilities, and the associated government supervision of banks. But a panic is
possible in any situation in which longer-term, illiquid assets are financed by short-term,
liquid liabilities and in which providers of short-term funding either lose confidence in the
borrower or become worried that other short-term lenders may lose confidence. The
combination of dependence on wholesale, short-term financing; excessive leverage;
generally poor risk management; and the gaps and weaknesses in regulatory oversight
created an environment in which a powerful, self-reinforcing panic could begin.4
Indeed, panic-like phenomena arose in multiple contexts and in multiple ways during the
crisis. The repo market, a major source of short-term credit for many financial institutions,
notably including the independent investment banks, was an important example. In repo
agreements, loans are collateralized by financial assets, and the maximum amount of the
loan is the current assessed value of the collateral less a safety margin, or haircut. The
secured nature of repo agreements gave firms and regulators confidence that runs were
unlikely. But this confidence was misplaced. Once the crisis began, repo lenders became
increasingly concerned about the possibility that they would be forced to receive collateral
instead of cash, collateral that would then have to be disposed of in falling and illiquid
markets. In some contexts, lenders responded by imposing increasingly higher haircuts,
cutting the effective amount of funding available to borrowers. In other contexts, lenders
simply pulled away, as in a deposit run; in these cases, some borrowers lost access to repo
entirely, and some securities became unfundable in the repo market. In either case, absent
sufficient funding, borrowers were frequently left with no option but to sell assets into illiquid
markets. These forced sales drove down asset prices, increased volatility, and weakened the
financial positions of all holders of similar assets. Volatile asset prices and weaker borrower
balance sheets in turn heightened the risks borne by repo lenders, further boosting the
incentives to demand higher haircuts or withdraw funding entirely. This unstable dynamic
was operating in full force around the time of the near failure of Bear Stearns in March 2008,
and again during the worsening of the crisis in mid-September of that year.5
Classic panic-type phenomena occurred in other contexts as well. Early in the crisis,
structured investment vehicles and many other asset-backed programs were unable to roll
over their commercial paper as investors pulled back, and the programs were forced to draw
on liquidity lines from banks or to sell assets.6 The resulting pressure on the bank liquidity
providers, evident especially in the market for dollar-denominated loans in short-term funding
markets, impeded the functioning of the financial system throughout the crisis. Following the
Lehman collapse and the "breaking of the buck" by a money market mutual fund that held
commercial paper issued by Lehman, both money market mutual funds and the commercial
paper market were also subject to runs.7 More generally, during the crisis, runs of short-term
uninsured creditors created severe funding problems for a number of financial firms,
including several large broker-dealers and also some bank holding companies. In some
cases, withdrawals of funds by creditors were augmented by "runs" in other guises - for
example, by prime brokerage customers of investment banks concerned about the safety of
cash and securities held at those firms or by derivatives counterparties demanding additional
margin.8 Overall, the emergence of run-like phenomena in a variety of contexts helps explain
the remarkably sharp and sudden intensification of the financial crisis, its rapid global spread,
and the fact that standard market indicators largely failed to forecast the abrupt deterioration
in financial conditions.
The multiple instances of run-like behavior during the crisis, together with the associated
sharp increases in liquidity premiums and dysfunction in many markets, motivated much of
5
For a theoretical discussion of "margin spirals" and related phenomena, see Markus K. Brunnermeier and
Lasse Heje Pedersen (2009), "Market Liquidity and Funding Liquidity," Review of Financial Studies,
vol. 22 (6), pp. 2201-38. Institutional details on the triparty repo market and a description of developments in
that market during the crisis are provided in Adam Copeland, Antoine Martin, and Michael Walker (2010), "The
Tri-Party Repo Market before the 2010 Reforms" (PDF), Federal Reserve Bank of New York Staff
Reports 477 (New York: Federal Reserve Bank of New York, November). The role of the "run on repo" in the
crisis is discussed in Gary B. Gorton and Andrew Metrick (2009), "Securitized Banking and the Run on Repo,"
NBER Working Paper Series 15223 (Cambridge, Mass.: National Bureau of Economic Research, August).
6
An empirical analysis of the run on ABCP is provided in Daniel Covitz, Nellie Liang, and Gustavo Suarez
(forthcoming), "The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market,"
Journal of Finance.
7
For an analysis of the determinants of runs on money market mutual funds during the crisis, see Patrick
McCabe (2010), "The Cross Section of Money Market Fund Risks and Financial Crises," Finance and
Economics Discussion Series 2010-51 (Washington: Board of Governors of the Federal Reserve System,
September).
8
Prime brokers provide a variety of services for hedge funds and other sophisticated institutional investors.
Their services include clearing of trades, financing of long securities positions, and borrowing of securities to
facilitate the establishment of short positions.
the Federal Reserve's policy response.9 Bagehot advised central banks - the only institutions
that have the power to increase the aggregate liquidity in the system - to respond to panics
by lending freely against sound collateral. Following that advice, from the beginning of the
crisis, the Fed, like other major central banks, provided large amounts of short-term liquidity
to financial institutions, including primary dealers as well as banks, on a broad range of
collateral.10 Reflecting the contemporary institutional environment, it also provided backstop
liquidity support for components of the shadow banking system, including money market
mutual funds, the commercial paper market, and the asset-backed securities markets. To be
sure, the provision of liquidity alone can by no means solve the problems of credit risk and
credit losses, but it can reduce liquidity premiums, help restore the confidence of investors,
and thus promote stability. It can also reduce panic-driven credit problems in cases in which
such problems result from price declines during liquidity-driven fire sales of assets.
The pricing of the liquidity facilities was an important part of the Federal Reserve's strategy.
Rates could not be too high; to have a positive effect, and to minimize the stigma of
borrowing, the facilities had to be attractive relative to rates available (or nominally available)
in illiquid, dysfunctional markets. At the same time, pricing had to be sufficiently unattractive
that borrowers would voluntarily withdraw from these facilities as market conditions
normalized. This desired outcome in fact occurred: By early 2010, emergency lending had
been drastically reduced, along with the demand for such lending.
The Federal Reserve's responses to the failure or near failure of a number of systemically
critical firms reflected the best of bad options, given the absence of a legal framework for
winding down such firms in an orderly way in the midst of a crisis - a framework that we now
have. However, those actions were, again, consistent with the Bagehot approach of lending
against collateral to illiquid but solvent firms. The acquisition of Bear Stearns by JPMorgan
Chase was facilitated by a Federal Reserve loan against a designated set of assets, and the
provision of liquidity to AIG was collateralized by the assets of the largest insurance company
in the United States. In both cases the Federal Reserve determined that the loans were
adequately secured, and in both cases the Federal Reserve has either been repaid with
interest or holds assets whose assessed values comfortably cover remaining loans.
To say that the crisis was purely a liquidity-based panic would be to overstate the case.
Certainly, an important part of the resolution of the crisis involved assuring markets and
counterparties of the solvency of key financial institutions, and that assurance was provided
in significant part by the injection of capital, including public capital, and the issuance of
guarantees - measures not available to the Federal Reserve. In these respects, the
Treasury-managed Troubled Asset Relief Program and the FDIC's Temporary Liquidity
Guarantee Program played critical roles. As I have noted, the Federal Reserve did help
restore confidence in the solvency of the banking system by leading the stress tests of the
19 largest U.S. bank holding companies in the spring of 2009. These stress tests, which
were both rigorous and transparent, helped make it possible for the tested banks to raise
$120 billion in private capital in the ensuing months.
The response to the panic also involved an extraordinary amount of international consultation
and coordination. Following a key meeting of the Group of Seven finance ministers and
central bank governors in Washington on October 10, 2008, the governments of other
industrial countries took strong measures to stabilize key financial institutions and markets.
Central banks collaborated closely throughout the crisis; in particular, the Federal Reserve
undertook swap agreements with 14 other central banks to help ensure adequate dollar
liquidity in global markets and thus keep credit flowing to U.S. households and businesses.
Conclusion
The financial crisis of 2007-09 was difficult to anticipate for two reasons: First, financial
panics, being to a significant extent self-fulfilling crises of confidence, are inherently difficult
to foresee. Second, although the crisis bore some resemblance at a conceptual level to the
panics known to Bagehot, it occurred in a rather different institutional context and was
propagated and amplified by a number of vulnerabilities that had developed outside the
traditional banking sector. Once identified, however, the panic could be addressed to a
significant extent using classic tools, including backstop liquidity provision by central banks,
both here and abroad.
To avoid or at least mitigate future panics, the vulnerabilities that underlay the recent crisis
must be fully addressed. As you know, this process is well under way at both the national
and international levels. I will have to leave to another time a discussion of the extensive
changes in regulatory frameworks, as well as the changes in the Federal Reserve's own
organization and practices, that have been or are being put in place. Instead, I will close by
noting that the events of the past few years have forcibly reminded us of the damage that
severe financial crises can cause. Going forward, for the Federal Reserve as well as other
central banks, the promotion of financial stability must be on an equal footing with the
management of monetary policy as the most critical policy priorities.