The bust exposed many structural flaws in the financial system that exacerbated its instability. Without being exhaustive, these included the instability of the tri-party repo system, which supported the nation’s short-term funding markets; the risks of runs in the money market mutual fund industry; and the risk of contagion caused by the huge volume of outstanding bilateral (noncentrally cleared) over-the-counter (OTC) derivative obligations between the major financial intermediaries. The tri-party repo system was centered on two of the major U.S. banks. The system matched investors and borrowers each day—with the investors lending cash, secured by Treasuries and other collateral, to the major securities firms. But, the system was unstable. In times of stress, clearing banks could be faced with very large single-firm exposures—of potentially hundreds of billions of dollars. Not surprisingly, when such counterparties became troubled, the clearing banks were less willing to take on these large intraday exposures. As a result, repo investors, who were primarily worried about getting repaid each morning, were motivated to simply withdraw from the market. As short-term investors withdrew funding, the liquidity buffer of the troubled securities firm was quickly exhausted, particularly as other counterparties to that firm demanded additional collateral to secure their own exposures. Structural weaknesses in the money market mutual fund industry—which was a major source of short-term wholesale funding to the securities industry and various non-bank financial corporations—also exacerbated the crisis. When Lehman Brothers failed, the value of its outstanding short-term obligations collapsed.

In particular, they need to have enough capital to be considered solvent even after sustaining significant losses, so that they can maintain the market access needed to recapitalize. They also need sufficient liquidity buffers so that they can respond to shocks without having to sell illiquid assets. The forced sale of illiquid assets can push asset valuations far below their fundamental value, which can increase insolvency risk. And, it is important that they not be overly reliant on short-term wholesale funding, which can evaporate during times of stress. Second, when we identify potential sources of instability that could amplify shocks, we need to make structural changes to the financial system to reduce or eliminate them. For example, the financial crisis made it clear that changes were needed in how tri-party repo transactions were unwound each day, net asset values were calculated for prime money market mutual funds, and OTC derivative obligations were cleared, settled, and risk-managed. Third, there should be a viable and predictable resolution regime. We need to be able to resolve a large, systemically important bank or securities firm in a way that limits contagion and stress on the rest of the financial system, while at the same time protecting the taxpayer against loss. Meanwhile, central counterparties (CCPs)—through which most standardized OTC derivatives must now be cleared—need to be open for business for the financial system to operate effectively.