James McAndrews: Modern recipes for financial crises
Remarks by Mr James McAndrews, Executive Vice President and Director of Research of the
Federal Reserve Bank of New York, at the University of Iowa, Iowa City, 4 December 2015.
* * *
Original presentation is on the Federal Reserve Bank of New York's website: Slides (PDF).
The author wishes to thank Tobias Adrian and Thomas Eisenbach for helpful discussions and comments on the
text of the speech. The views expressed are those of the author and do not necessarily represent the views of the
Federal Reserve Bank of New York or of the Federal Reserve System.
Introduction
Franklin Delano Roosevelt, in his first fireside chat on March 12, 1933, cogently explained the
mechanisms that led to the complete collapse of the banking system in the United States
earlier that month:
"First of all, let me state the simple fact that when you deposit money in a bank, the bank does
not put the money into a safe deposit vault. It invests your money in many different forms of
credit - in bonds, in commercial paper, in mortgages and in many other kinds of loans. In other
words, the bank puts your money to work to keep the wheels of industry and of agriculture
turning around. A comparatively small part of the money that you put into the bank is kept in
currency - an amount which in normal times is wholly sufficient to cover the cash needs of the
average citizen. In other words, the total amount of all the currency in the country is only a
comparatively small proportion of the total deposits in all the banks of the country.
"What, then, happened during the last few days of February and the first few days of March?
Because of undermined confidence on the part of the public, there was a general rush by a
large portion of our population to turn bank deposits into currency or gold - a rush so great
that the soundest banks couldn't get enough currency to meet the demand. The reason for this
was that on the spur of the moment it was, of course, impossible to sell perfectly sound assets
of a bank and convert them into cash, except at panic prices far below their real value. By the
afternoon of March third, a week ago last Friday, scarcely a bank in the country was open to
do business. Proclamations closing them, in whole or in part, had been issued by the
Governors in almost all the states. It was then that I issued the proclamation providing for the
national bank holiday, and this was the first step in the Government's reconstruction of our
financial and economic fabric."1
Roosevelt understood the recipe for a banking crisis: fractional reserve banking and an
undermined confidence by the public in banks, which led to widespread runs on banks. In turn
that led to panic prices on bank assets and bank closures. During the Depression, the basic
elements for the prevention of banking panics were put in place or strengthened: an extensive
and well-designed system of federal deposit insurance, broad access by banks to the discount
window, and sound supervision of banks.2
After 1933, the United States did not experience another major broad financial crisis for
74 years, until 2007. Even through significant macroeconomic upheavals, and the savings and
loan crisis of the 1980s, the Continental Illinois failure in 1984, the Long-Term Capital
Management crisis of 1998, and the dot-com crash in the early 2000s, a widespread financial
crisis did not occur. Although the savings and loan crisis was very costly to taxpayers, for the
most part the system of deposit insurance, discount window access, and supervision
prevented runs and large spillovers into the real economy.
The bank runs during the Great Depression have been the subject of extensive research.
Economic theory provided increasingly compelling explanations for the mechanisms that lead
to bank runs. The widely cited work by Douglas Diamond and Philip Dybvig in 1983 explained
the economic logic behind why banks exist and what makes them vulnerable to runs. In their
model, banks fund illiquid assets with liabilities payable on demand and provide an important
form of insurance for depositors. So long as the demand of depositors for currency withdrawals
are relatively uncorrelated, the bank provides a safe place for housing one's savings while
earning a rate of return higher than that available to people simply by storing currency.
However, coordination failure, such as an instance when everyone thinks that everyone else
will withdraw their deposit today, can give rise to instability and lead to bank runs. That general
theory has been extended in many ways. One of the lessons of that work is that deposit
insurance (backed by the government's money creation power) and discount window access
can mitigate or even eliminate bank runs.
So why did we experience a crisis in 2007, one in which we in the United States did not observe
widespread instances of depositors lined up outside of their banks demanding currency?3
During the decades from 1933 to 2007, and especially since the rapid growth of the market
intermediated financial system in the 1980s, the financial system in the United States has
grown in complexity and in reliance on financial institutions that aren't commercial banks.
Those institutions intermediate corporate bond markets, money markets for short-term credit,
stock markets in which firms can issue equity claims, and derivative markets. All of these
markets rely on non-banks such as dealers, finance companies, insurers, and many other
types of specialists. It is important to recognize that the financial crisis of 2007-09 in the United
States did not include widespread runs on bank deposit accounts, the hallmark of the crisis in
the early 1930s. However, there has been a growing recognition that the financial system as a
whole can be fragile beyond banks, and that runs can occur on a wide range of financial
intermediaries. So what is a modern recipe for a financial crisis?
Menu
What is a financial crisis?
First, let's define a financial crisis. There are many types of financial crises including currency
crises in which the value of a country's currency plummets, as happened in Iceland in 2008
along with its major banking crisis; fiscal crises in which a country's government defaults on its
debt or has the debt restructured, as happened in Greece in 2010 and 2014; and general
financial crises, often called banking crises, which occurred in several parts of the world in
2008-09.4 What is a banking crisis, specifically? The economists Luc Laeven and Fabián
Valencia (2012) have a clear definition, but similar definitions have been offered by other
researchers:
A banking crisis is defined as systemic if two conditions are met:
1) Significant signs of financial distress in the banking system (as indicated by significant
bank runs, losses in the banking system, and/or bank liquidations)
2) Significant banking policy intervention measures in response to significant losses in
the banking system.
To be clear, and to apply this definition to the U.S. crisis in 2007-09, I'll expand it from the
banking system to the financial system more broadly, as many financial firms that experienced
distress during the most recent crisis weren't licensed as banks. It may seem odd to include
policy interventions to be counted as a sign of a financial crisis, but when deposit insurance
and lender of last resort services are available, a crisis may not kick off a bank run. That means
the government must intervene to keep the stress from worsening, and so extraordinary action
by the government can itself be a gauge of the severity of a crisis. Laeven and Valencia review
the frequency of financial crises around the world and count 147 crises since 1970.
What problems are caused by a financial crisis?
The clearest outcome of a financial crisis is a loss of output - in other words, a severe and
long-lasting recession. Using the same dataset they used to identify crises, Laeven and
Valencia found that in advanced-economy nations, the median cumulative decline in output
accompanying a financial crisis was 33 percent of annual gross domestic product, or one-third
of an economy's output for a year. In addition, the median growth in government debt was
21 percent of GDP, and the median fiscal cost of the crisis-related spending was 3.8 percent
of GDP.
Other studies confirm these grim statistics. Reinhart and Rogoff (2009) point out that
recoveries from financial crises are weaker and slower than recoveries from recessions that
don't accompany a financial crisis. Employment growth is slower during recoveries from
financial crises, and the associated higher unemployment can have long-lasting effects on a
whole generation of young workers who sustain long spells of joblessness. There are many
other maladies that come along with financial crises.
Ingredients
Several economic researchers agree that one crucial ingredient in creating the vulnerabilities
that can foster a financial crisis is a buildup of debt.5 In particular, a "credit boom," that is, a
high and fast-growing ratio of credit to GDP, is one of the precursors to a financial crisis. Other,
somewhat less reliable precursors include a prior financial liberalization or deregulation,
housing price booms, and external imbalances (in practice, large inflows of capital from outside
the country).
The complication is that while most financial crises have been preceded by a credit boom, not
all credit booms have been followed by a financial crisis. In fact, a credit boom has been
followed by a financial crisis in only about 30 percent of the cases.6 Consequently, there are
good booms, which don't end in a crisis, and bad booms, or "booms gone wrong" that do end
in a crisis. Given that credit booms often accommodate the real and pressing needs of a
growing economy, simply preventing credit booms, if that were even possible, could have the
effect of choking off desirable growth and thus be more costly for society over the longer run.
Nevertheless, it is difficult a priori to distinguish good and bad booms, and, furthermore, to
determine the mechanisms that generate crises when the economy has become vulnerable to
one, that is, when the economy has high debt, a weakening macroeconomy, and other such
elements. Even so, as previous studies have indicated, debt growth shifts the conditional
distribution of economic outcomes to put more weight on events in which debtors must
unexpectedly cut back their spending plans to repay debt, a vulnerability that is not present in
the absence of debt. Therefore, as I'll explain later, forward-looking comprehensive supervision
of the financial system is a key element in attempting to distinguish a healthy expansion of
credit from a more dangerous and fragile buildup of debt.
Recipes
In what follows, I'll outline recent findings on some of the possible mechanisms that can
generate a modern financial crisis, one that is not characterized, like the U.S. banking crisis in
1931-33 by depositors demanding currency from their banks. In particular, I'll focus on two
strands of research that identify mechanisms that can amplify small initial disturbances in the
economy to produce significant financial distress. My review is selective, as I don't aim to cover
all the possible factors that researchers have suggested can contribute to financial crises, but
instead to focus on two topics that reveal some of the main mechanisms at play.
The first mechanism is the procyclicality of financial intermediary leverage; banks and other
financial intermediaries, notably broker-dealers, increased their leverage during the growth
years of the 2000s, issuing increasing amounts of debt, but little equity. But as financial
volatility increased in 2007, they began to deleverage, a process that produced stresses for
many institutions and people throughout the economy, much like the distress caused by classic
bank runs.
The second mechanism I'll review is the role played by the private sector in creating
moneylike assets, such as repos, commercial paper, and other short-term and ostensibly safe assets.
When able to issue such assets, private issuers pay a very low interest rate, as others in the
economy demand the apparent safety that those assets provide. That situation gives the
private financial sector strong incentives to issue money-like claims. However, the excessive
issuance of such instruments can lead, at some point, to a loss of confidence in them. In turn,
that can reduce demand for these instruments and lead again to a rapid deleveraging by the
issuers of these instruments. Much like the case that F.D.R. discussed for banks in the 1930s,
the runs on these short-term debt instruments can lead to fire sales of assets by the institutions
that were relying on the issuance of money-like instruments to finance their portfolios - and
those sales cause distress for many others throughout the economy.
Procyclical leverage of financial intermediaries
In a series of papers, Tobias Adrian and coauthors have made a number of findings about the
behavior of financial intermediaries, that is, banks, broker-dealers, and other financial
companies, and how their leverage varies over time. So rather than focusing on the debt
burden of the government, or households, or nonfinancial corporations, this line of work
focuses on the debt burden of the financial sector itself.7
It is important to mention that, in a
series of studies, Atif Mian and Amir Sufi have proposed a complementary mechanism in which
they focus on the increase in household debt as a strongly predictive factor in explaining the
depth of the recession associated with the financial crisis.8 Across the United States, regions
in which household leverage was fueled by more aggressive lending tended to have larger
subsequent busts. Hence the procyclicality of household and financial sector leverage were
tightly intertwined.
The first and central finding is that financial intermediary balance sheet growth is highly
procyclical. This finding is broadly consistent with how we think banks operate and the role
they perform in providing financing to households and firms: As the economy expands, banks
find more potentially profitable projects to which to lend, and also find it relatively easy to attract
more funding, as households and businesses have more savings to invest. A more cautionary
finding is that the size of bank balance sheets tends to forecast aggregate economic volatility.
Consequently bank lending booms may portend more mixed economic outcomes.
Other studies in this vein suggest some of the mechanisms that might be behind the greater
future volatility. First, banks have procyclical leverage: lending booms by banks are financed
by debt, not equity. Consequently, the increased leverage of banks can result in a deterioration
of the quality of bank lending through a type of moral hazard that can occur if debt becomes
too easy for the banks to raise or if volatility in financial markets is suppressed. Another finding
by Adrian and his coauthors is that banks' incentives and ability to lend becomes highly
sensitive to financial market volatility. When the economy is in the upside of the cycle, volatility
and other measures of risk may be low precisely because of the abundance of debt financing,
masking the level of underlying risk in the economy, which may lead to excessive, and
eventually unsustainable, growth in bank lending.
The procyclical leverage of banks is associated with other features of the financial economy
and its dynamics. For example, the leverage of financial intermediaries influences the pricing
of assets: once again, this feature can impart procyclicality to asset pricing. When risk
measures are low during a growth and boom phase of the cycle, asset prices tend to be
supported, but during the contractionary phase, asset prices can drop, with risk premia rising,
which, in turn, can lead to further contractions in credit by lenders, resulting in a negative
feedback loop that can amplify the initial shock to asset prices.
Finally, the procyclical leverage of financial intermediaries is tied to systemic risk, suggesting
that the leverage of financial intermediaries is a key factor behind economy-wide financial
crises. Once again, a potential "macroprudential" regulator - one that is attempting to reduce
the risk of a financial crisis but also attempting to stabilize the macroeconomy - would face a
risk-return tradeoff: Allowing a buildup in financial intermediary leverage as the economy grows
can assist in achieving macroeconomic objectives such as full employment, but risks a more
severe downturn if such leverage growth becomes excessive. Making those judgments is
inherently difficult.
The benefit of being a money issuer
Society demands money for many purposes. Money provides a good way for people to store
value safely, and it can be used as a means of exchange. These are classic and enduring
features of money. For the purpose of this talk, by "money" I mean a broad definition of money
- what some would call "money-like" assets that can provide the monetary functions of storing
value and serving as a medium of exchange. Those include both short-term government debt
and short-term borrowing by financial intermediaries, especially borrowing that is designed to
be extremely safe, such as repurchase agreements, or repos.
A repo is a fairly modern instrument that I'll describe in a bit more detail, as repos played an
important role in the buildup of intermediary leverage and the issuance of private-sector
money-like instruments during the lead-up to the crisis of 2007-09. A repo is a sale of a security
with an agreement to buy it back on a later date (the most common term for a repo is overnight,
but the term can be for a longer period, such as one-month as well). The difference in the
purchase and sale prices constitutes a rate of interest paid by the institution that is borrowing
the money (or selling the security). The advantage of the sale and resale arrangement is that,
in the event that the borrower does not return the money it owes, the party that purchased the
security can keep it, avoiding the costs, delays, and uncertainty associated with making its
claim in bankruptcy court; these advantages are confined to certain types of securities and has
been allowed by supporting legislation.
Repos are just one such way that a private intermediary can provide a high degree of safety
to its lenders, and others include asset-backed commercial paper, money market mutual fund
shares, and auction-rate securities. However these private money-like assets are created,
those that succeed in providing that elusive money-likeness confer significant benefits on their
creators. A now widely confirmed finding regarding the issuance of money-like assets is that
they can be issued at lower interest rates than other types of debt, saving the issuer from
greater interest expense.
That result comes in two steps. First, a number of studies show that short-term Treasury bills
(which are a publicly provided type of money-like asset) enjoy a "liquidity premium," especially
when the supply of Treasury bills is relatively low.9 Short-term Treasury bills can provide
various money-like services for larger institutions because they are so safe. Deposit insurance
is limited (currently it is limited to deposits of $250,000) so large institutions that want to hold
funds safely for short periods cannot find that safety directly with bank deposits. Instead,
shortterm Treasury bills can provide a convenient way for large institutions to hold wealth in a safe
form. Because the Treasury bills are short-term, their prices don't experience much variation,
and they are easily transferred and used as collateral. Hence, they provide those features of
money I mentioned earlier, namely a good store of value and a means of exchange.
A second finding from these studies is that when the U.S. Treasury issues relatively smaller
amounts of Treasury bills, the private-sector issuance of money-like assets increases, taking
advantage of the liquidity premium that large institutions are willing to pay for their safety and
convenience. So when the government funds itself with relatively more long-term debt, firms
fill the resulting gap by issuing more short-term debt.10
In related work, Jeremy Stein (2012) points out that, notwithstanding their private benefits,
there are systemic risks involved when the private sector creates money-like assets. For many
reasons, if private intermediaries run into difficulty issuing those assets or in rolling over their
short-term debt, then they must deleverage abruptly. In fact, the crisis of 2007-09 was
characterized by runs on all four of the money-like instruments I mentioned earlier, namely
repo, asset-backed commercial paper, money market mutual fund shares, and auction-rate
securities. Those runs can lead to selling off the loans or securities that were financed by the
issuance of those instruments and also may initiate fire sales.
A fire sale is caused when assets are sold at a time when many of the likely buyers of those
assets do not have the capacity to purchase them, leading to severe downward price
adjustments. These price movements create additional problems for other financial sector
players, as the declining value of the securities that were sold often means that the value of
the securities that they hold are also marked down, reducing their ability to obtain or retain
financing to hold their portfolio of securities. This can lead to additional sales, worsening the
fire sale conditions, in a negative feedback loop that amplifies the initial shock to the financial
sector.
The emphasis on fire sales when private intermediaries encounter difficulty rolling over their
short-term debt is complemented by research that posits that the role of banks is to create and
preserve liquidity of their money-like liabilities such as deposits, repos, and other short-term
debt.11 In normal times, these instruments are very safe and it is believed by people and
institutions that invest in them that no special monitoring of those instruments is needed.
Consequently, investors remain ignorant of the precise condition of the intermediary to whom
they are lending, or of the securities that back their loan. However, once conditions worsen,
suddenly the nature of the debt changes, in that the people and institutions that hold the debt
realize they must expend resources to monitor their borrower. But, at that point, they are not
in a good position to monitor that firm, so they simply refuse to extend the loan to it when the
loan comes due, greatly amplifying the initial cause of the need to monitor further. This has the
effect of the old-style bank run: suddenly the financial intermediary is caught short of the ability
to finance its portfolio, and must reduce its indebtedness quickly, again, possibly triggering fire
sales and creating negative externalities to others.
Setting the table
Classic and modern crises
In the financial crisis that initiated the Great Depression, we saw a classic banking panic. At
the peak of an economic expansion, a stock market crash signaled a revision to growth
expectations, or possibly a change in the willingness of people to assume risk. Around the
country many banks (whose deposits were not insured) experienced difficulty in meeting
depositors' withdrawal demands, and bank runs began to occur, at first sporadically. In these
runs, depositors formed lines stretching from teller windows to outside the bank, clearly
indicating to the public that the bank was in distress. Bank runs waxed and waned for a few
years prior to the generalized runs that preceded F.D.R.'s declaration of a bank holiday. F.D.R.
explained well the consequences of a bank run: the banks that were run could only close their
doors, or sell their assets at panic prices. Either of those actions conferred negative
externalities on the economy more broadly. With the closure of a bank, the community lost
access to credit and to a safe place into which it could deposit its paychecks and savings. The
knowledge about borrowers and their creditworthiness was lost, and even if other banks would
expand their business, that loss of information was costly to the efficiency of the economy, and
in notable research Ben Bernanke (1983) measured the very negative effect that bank closures
had on economic performance.
In the U.S. financial crisis of 2007-09, there were no widespread bank runs: in general
depositors did not line up at their bank and request their deposits, even for banks that were
widely reported to be in poor financial condition. This is likely the case because of the
widespread understanding of U.S. federally insured deposit insurance, which protects
depositors' funds up to the current limit of $250,000, and the presence of the discount window,
by which banks can increase their cash holdings to meet withdrawal demands without having
to sell assets at panic prices.12
However, the financial crisis of 2007-09 manifested another type of run on banks as well as
non-banks, a run on the short-term, non-deposit debt issued by the intermediaries. This is a
point made clearly by Gary Gorton (2012). These runs weren't clearly and easily visible to the
public, and this fact impeded the quick understanding of the severity and potential
consequences of the run that was underway.
I've outlined two strains of thought that provide models for us to understand the mechanisms
that amplify what might initially be small shocks into large and dangerous events for the
economy: the procyclical leverage of financial intermediaries and their sensitivity to measures
of financial risk, such as volatility, and the potential for private intermediaries to issue
moneylike instruments. When the economy is vulnerable to a financial crisis - that is when the levels
of debt are high and the macroeconomy is at or past a peak, and in some cases, a housing
boom is ending - then financial intermediary leverage and the issuance of money-like debt
instruments can become excessive. Such excess can lead to a rapid scramble to deleverage
- that is, to reduce levels of debt, causing fire sales and failures of financial intermediaries,
which, in turn, confers further distress on the financial economy and the working of the
macroeconomy generally, as important sources of credit are blocked from reaching
households and firms.
In essence, I've argued that there are two views of the mechanisms that could lead to a crisis:
one is about excessive leverage or the scarcity of loss-bearing capacity that builds up in an
expanding economy and the other is about the excessive provision of liquidity in the private
sector, or excess private money creation. Of course, liquidity and leverage go hand in hand:
Private money creation enables firms that issue it to take on high leverage, both in the financial
and the nonfinancial sectors. Part of the puzzle of the crisis of 2007-09 was that the excessive
leverage and private money creation took place outside of commercial banks, and outside of
firms that were subject to broad consolidated supervision - in the "shadows" as some have put
it. It is important that we recognize that in the modern era the conditions for a financial crisis
can be created by nonbanks.
A lesson of the crisis of 2007-09 was that financial crises, modern ones, do not have to be
characterized by lines from bank teller windows in which depositors are withdrawing cash, or
even be centered in banks. Instead, in a more market-oriented, in contrast to bank-oriented
financial system, different sources of stress come to the fore. While employing a different
recipe, the flavors of the crises are the same: financial intermediaries, through having
overextended credit or engaged in an over-reliance on the issuance of short-term debt, or in
the midst of a general panic, have difficulty in raising funds and are forced to sell off positions
abruptly, putting further downward pressure on prices, worsening the situation systematically.
Preparing for (unwanted) guests
In response to the 2007-09 crisis, the policies of the Federal Reserve were focused primarily
on liquidity injections, which can be thought of as replacing the privately created money that
was being withdrawn from circulation as intermediaries delevered. The U.S. Treasury and the
Federal Deposit Insurance Corporation extended guarantees for money market mutual fund
shares, issuance of certain types of debt by bank holding companies and unlimited amounts
of deposits in transactions accounts of commercial banks. Later, with the passage of the TARP
legislation, the federal government addressed the excessive leverage and shortages of
lossbearing capacity through the injections of capital in October 2008 and in April 2009 in
conjunction with the Supervisory Capital Assessment Program, or stress test of the major U.S.
bank holding companies.
Ultimately, the 2007-09 crisis was about both leverage and liquidity in the financial system as
a whole, and not only in the tightly supervised sector of banking firms. This suggests that official
sector efforts should aim at forward-looking monitoring of financial vulnerability that take both
leverage and maturity transformation into account, and to broaden supervision to include
broader coverage of the financial sector. In addition to many other efforts, the Federal Reserve
is conducting tests of exactly that sort through its capital and liquidity assessments, the
Comprehensive Capital Analysis and Review, or CCAR, and the Comprehensive Liquidity
Analysis and Review, or CLAR. CCAR is the Federal Reserve's annual process for evaluating
capital adequacy of large and complex financial firms under normal and stressed conditions.
CLAR is the Federal Reserve's annual, horizontal exam to evaluate the liquidity position and
liquidity risk management practices of those firms. CCAR and CLAR are applied to bank
holding companies, firms that now include many of the broker-dealers and other nonbank
intermediaries involved in the market-based system of intermediation. Both of these
forwardlooking assessments attempt to gauge the vulnerability to a crisis by examining the capital and
liquidity resources the largest bank holding companies have to withstand the stresses that
accompany a severe economic downturn.
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