on asset prices. the resulting credit contractions adversely affected the real economy, setting up an adverse feedback loop that exacerbated the initial losses. walter bagehot, 1873. lombard street. london : henry s. king and co. given the parallels between the events of 1907 and 2007 and, more importantly, the similarities of the lessons learned from those episodes, i believe the most instructive name for our latest financial crisis is the “ panic of 2007 ”. in the rest of my remarks, i will explore in greater detail the factors behind the panic, as well as the responses by the federal reserve. the first question to explore is the extent to which the financial system had evolved over the past several decades. 3 over this period, demand deposits lost their market share to money market mutual funds, which, while considered safe, are not guaranteed like deposits. this made it increasingly difficult and less profitable for banks to fund loans on their balance sheets using deposits. securitization markets developed where loans could be funded through the market by investors. in addition, money market mutual funds, securities lenders, institutional investors and businesses needed a safe way to deposit funds where they would earn interest but retain ready access to their funds. repurchase agreements or “ repos ” developed to serve this need. a repo is a short - term collateralized loan that shares many characteristics with a demand deposit except that repos are not guaranteed. at the same time, large firms increasingly raised funds by issuing commercial paper in the market rather than relying on bank loans – with the money market mutual funds being large investors in this paper. large banks, as well, came to rely at the margin on non - deposit funding through the interbank funding market. the fed acted as the lender of last resort for this market. this system of market - based credit intermediation has been called the “ shadow banking system ”. the shadow banking system grew at a very fast rate over the past several decades. chart 1 shows that by 1990, mortgage originations in the shadow banking system equaled originations in the banking system, and grew to more than double the level in the banking system by 2008. chart 2 highlights the growth in securitization across many different asset categories besides residential mortgages, such as commercial real estate loans, auto loans, credit card loans and student loans. a direct consequence of this growth was that the short - term liabilities associated with the shadow banking system – repos

management practices and supervisory oversight has to focus much more attention on strengthening shock absorbers within institutions and across the infrastructure against very bad macroeconomic and financial outcomes, however implausible they may seem in good times. after we get through this crisis and the process of stabilization and financial repair is complete, we will put in place more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning. this is important for reasons that go beyond the implications of excess leverage for the fate of any particular financial institution. as we have seen, the process of de - leveraging by large but relatively strong institutions can cause significant collateral damage for market functioning and for other financial institutions. inducing institutions to hold stronger cushions of capital and liquidity in periods of calm may be the best way to reduce the amplitude of financial shocks on the way up, and to contain the damage on the way down. stronger initial cushions against stress reduces the need to hedge risk dynamically in a crisis, reducing the broader risk of a self - reinforcing, pro - cyclical margin spiral, such as we have seen in this crisis. how should we decide where to set these constraints on risk - taking? this is hard, but the objective should be to offset the benefits and the moral hazard risk that come from access to central bank liquidity in crises, without setting the constraint at a level that will only result in pushing more capital to the unregulated part of the financial system. risk management and oversight now focuses too much on the idiosyncratic risk that affects an individual firm and too little on the systematic issues that could affect market liquidity as a whole. to put it somewhat differently, the conventional risk - management framework today focuses too much on the threat to a firm from its own mistakes and too little on the potential for mistakes to be correlated across firms. it is too confident that a firm can adjust to protect itself from its own mistakes without adding to downward pressure on markets and takes too little account of the risk of a flight to safety – a broad - based, marketwide rush for the exits as the financial system as a whole de - leverages and tries collectively to move into more liquid and lower risk assets of government obligations. third, although supervision has to focus first on the stability of the core of financial institutions, it cannot be indifferent to the scale of leverage and risk outside the regulated institutions. i do not believe it would be desirable or