Interpreting the Crisis

Business Times, 26 Aug 2009

The events of last September and October exhibited some features of a classic panic

This is the second and final part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21.

HOW should we interpret the extraordinary events of the past year, particularly the sharp intensification of the financial crisis in September and October? Certainly, fundamentals played a critical role in triggering those events. As I noted earlier, the economy was already in recession, and it had weakened further over the summer. The continuing dramatic decline in house prices and rising rates of foreclosure raised serious concerns about the values of mortgage-related assets, and thus about large potential losses at financial institutions. More broadly, investors remained distrustful of virtually all forms of private credit, especially structured credit products and other complex or opaque instruments.

At the same time, however, the events of September and October also exhibited some features of a classic panic, of the type described by (British economist and journalist Walter) Bagehot and many others.

A panic is a generalised run by providers of short-term funding to a set of financial institutions, possibly resulting in the failure of one or more of those institutions. The historically most familiar type of panic, which involves runs on banks by retail depositors, has been made largely obsolete by deposit insurance or guarantees 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 suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence.

Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit.

Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements. In repo agreements, the asset being financed serves as collateral for the loan, and the maximum amount of the loan is the current assessed value of the collateral less a haircut.

In a crisis, haircuts typically rise as short-term lenders attempt to protect themselves from possible declines in asset prices. But this individually rational behaviour can set off a run-like dynamic: As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.

This unstable dynamic was apparent around the time of the near- failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September.

As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry.

Panic-like phenomena

Panic-like phenomena occurred in other contexts as well. Structured investment vehicles and other asset-backed programmes that relied heavily on the commercial paper market began to have difficulty rolling over their short-term funding very early in the crisis, forcing them to look to bank sponsors for liquidity or to sell assets.

Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market, as I have discussed. More generally, during the crisis, runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of 'runs' - for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.

The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions.

Mr Bagehot instructed 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 central banks) has provided large amounts of short-term liquidity to financial institutions. As I have discussed, it also provided backstop liquidity support for money market mutual funds and the commercial paper market, and added significant liquidity to the system through purchases of longer-term securities.

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 is noteworthy that the use of Fed liquidity facilities has declined sharply since the beginning of the year - a clear market signal that liquidity pressures are easing and market conditions are normalising.

What does this perspective on the crisis imply for future policies and regulatory reforms? We have seen during the past two years that the complex interrelationships among credit, market, and funding risks of key players in financial markets can have far-reaching implications, particularly during a general crisis of confidence.

In particular, the experience has underscored that liquidity risk management is as essential as capital adequacy and credit and market risk management, particularly during times of intense financial stress. Both the Basel Committee on Banking Supervision and the US bank regulatory agencies have recently issued guidelines for strengthening liquidity risk management at financial institutions. Among other objectives, liquidity guidelines must take into account the risks that inadequate liquidity planning by major financial firms pose for the broader financial system, and they must ensure that these firms do not become excessively reliant on liquidity support from the central bank.

But liquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.

Systemwide approach

The role of liquidity in systemic events provides yet another reason why, in the future, a more systemwide or macroprudential approach to regulation is needed. The hallmark of a macroprudential approach is its emphasis on the interdependencies among firms and markets that have the potential to undermine the stability of the financial system, including the linkages that arise through short-term funding markets and other counterparty relationships, such as over-the-counter derivatives contracts. A comprehensive regulatory approach must examine those interdependencies as well as the financial conditions of individual firms in isolation.

Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge.

As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year, monetary, fiscal and financial policies around the world have been aggressive and complementary.

Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

Although we have avoided the worst, difficult challenges still lie ahead. We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years.

I hope and expect that, when we meet here a year from now, we will be able to claim substantial progress towards both those objectives.