Dudley: More Lessons from the Crisis

More Lessons from the Crisis - FEDERAL RESERVE BANK of NEW YORK

Speech

More Lessons from the Crisis

November 13, 2009

William C. Dudley

, President and Chief Executive Officer

Remarks at the Center for Economic Policy Studies (CEPS) Symposium, Princeton, New Jersey

Thank you for having me here to speak today. It is a real pleasure to

have this opportunity to speak at CEPS again—this is a great forum to

talk about policy issues. Tonight I want to discuss some of the challenges

we face in making our financial system more robust. We have

learned a great deal over the past two years about our financial system and

its vulnerabilities. The task ahead is to put these lessons to good use. Our

goal must be to make the financial system more resilient to shocks. If

we can do that successfully, we should be able to reduce the risk of financial

crises.

In assessing the causes of this crisis, one clear culprit was the failure

of regulators and market participants alike to fully appreciate the strength

of the amplifying mechanisms that were built into our financial system. These

mechanics exacerbated the boom on the way up and the bust on the way down. Only

by better understanding the sources of these damaging dynamics can we construct

solutions that will strengthen our financial system and make it more robust.

Today, I am going to focus mainly on the extraordinary liquidity events that

played out during this crisis. I will tackle this topic in four

parts. I will begin by describing how funding dried up rapidly for firms

such as Bear Stearns, Lehman Brothers, and AIG. I then will propose

a conceptual framework that might prove helpful in better understanding what

went wrong on the liquidity front. With this conceptual framework in

hand, I will then suggest some concrete steps we might take toward making the

financial system more resilient—cautioning that there are no magic bullets. Finally,

I will talk about the major initiatives that are already underway to help reduce

the risk of future liquidity crises.

As always, my remarks reflect my own views and opinions and not necessarily

those of the Federal Reserve System.

At its most fundamental level, this crisis was caused by the rapid growth

of the so-called shadow banking system over the past few decades and its remarkable

collapse over the past two years. Let me give you some figures to illustrate

the disparity between the growth of what I will call the “traditional” commercial

banking system and the shadow banking system in recent years. At

the end of 2006, the shadow banking system had grown so large that U.S. commercial

banks’ share of credit market assets had fallen to only 17.7 percent,

down from 27.3 percent in 1980.

With this shift in the composition of activity also came an important change

in the composition of funding, particularly in the middle part of this decade.

Commercial paper outstanding grew from $1.3 trillion at the end of 2003 to

a peak of about $2.3 trillion. Repo funding by dealers to nonbank financial

institutions—as measured by the reverse repos on primary dealer balance

sheets—grew from less than $1.3 trillion to a peak of nearly $2.8 trillion

over this period. In contrast, commercial bank retail deposits rose by

less than 30% in the four year period from 2003 to 2007.

Though the shadow banking system was often credited with better distributing

risk and improving the overall efficiency of the financial system, this system

ultimately proved to be much more fragile than we had anticipated. Like

the traditional banking system, the shadow banking system engaged in the maturity

transformation process in which structured investment vehicles (SIVs), conduits,

dealers, and hedge funds financed long-term assets with short-term funding. However,

much of the maturity transformation in the shadow system occurred without the

types of stabilizing backstops that are in place in the traditional banking

sector.

A key vulnerability turned out to be the misplaced assumption that securities

dealers and others would be able to obtain very large amounts of short-term

funding even in times of stress. Indeed, one particularly destabilizing

factor in this collapse was the speed with which liquidity buffers at the large

independent security dealers were exhausted. To take just one illustrative

example, Bear Stearns saw a complete loss of its short-term secured funding

virtually overnight. As a consequence, the firm’s liquidity pool

dropped by 83 percent in a two-day span.

These liquidity dynamics were driven by two main factors. The

first factor was the underlying stress on dealer balance sheets as the prices

on complex collateralized debt obligations (CDOs), private label residential

mortgage-backed securities (RMBS), and commercial real estate-related assets

fell sharply and uncertainty about underlying asset values rose sharply. The

uncertainty stemmed, in part, from the lack of transparency about what prices

these assets could be sold for, which, in turn stemmed from the difficulty

of valuing these extremely complex and heterogeneous securities.

The stress on underlying asset prices and the uncertainty about the valuations

of pools of illiquid assets caused investors to become concerned about the

solvency of some of the weaker dealers.

These

concerns contributed to liquidity pressures, which, in turn, led to forced

asset sales by dealers and others. These sales both further depressed

asset prices and increased asset price volatility.

The second factor contributing to the liquidity crisis was the dependence

of dealers on short-term funding to finance illiquid assets. This short-term

funding came mainly from two sources, the tri-party repo system and customer

balances in prime brokerage accounts. By relying on these sources of

funding, dealers were much more vulnerable to runs than was generally appreciated.

Consider first tri-party repo, a market in which money market funds, securities

lending operations, and other institutions finance assets mainly on an overnight

basis. As asset prices fell and volatility climbed during this period,

the financial condition of some dealers became more troubled. As a result,

some investors in this market became worried about the risk that they might

not get their cash returned in the morning, but instead might be stuck with

the collateral that secured their lending. Investors responded by increasing

their haircuts—that is the margin of extra collateral used to secure

their funding—and reducing the range of collateral they would accept

as security for their lending. Of course, these very rational reactions

on the part of investors only further weakened the liquidity positions of the

major securities firms.

A similar dynamic occurred in the context of prime brokerage accounts. Some

institutions treated the free cash balances associated with these accounts

as if they were a stable source of funding. Implicitly, they assumed

that these balances would be “sticky” due to the strength of broader

business relationships and the cost incurred by customers in shifting the business

elsewhere. However, once markets became strained, this assumption of

stable funding proved to be false. Prime brokerage customers began to

withdraw their free credit balances and some moved their business elsewhere. Both

of these steps reduced dealer liquidity buffers and further tightened the funding

noose.

In the case of the tri-party repo market, the stress on repo borrowers was

exacerbated by the design of the underlying market infrastructure. In

this market, investors provide cash each afternoon to dealers in the form of

an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate

tri-party repo systems permit dealers to return the cash to their investors

and to retake possession of their securities portfolios by overdrawing their

accounts at the clearing banks. During the day, the clearing banks

finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer

becomes troubled or is perceived to be troubled, the tri-party repo market

can become unstable. In particular, if there is a material risk that

a dealer could default during the day, the clearing bank may not want to return

the cash to the tri-party investors in the morning because the bank does not

want to risk being stuck with a very large collateralized exposure that could

run into the hundreds of billions of dollars. Overnight investors, in

turn, don’t want to be stuck with the collateral. So to avoid such

an outcome, they may decide not to invest in the first place. These self-protective

reactions on the part of the clearing banks and the investors can cause the

tri-party funding mechanism to rapidly unravel. This dynamic explains

the speed with which Bear Stearns lost funding as tri-party repo investors

pulled away quickly.

Despite the strains created by the collapse of Bear Stearns, the “rivets” of

the tri-party repo system held for several reasons. First, Bear Sterns

did not fail; instead it was acquired by JPMorgan Chase with assistance from

the Federal Reserve. Second, the Federal Reserve stepped in to support

the tri-party repo system by implementing the Primary Dealer Credit Facility

(PDCF). The PDCF essentially placed the Fed in the role of the tri-party

repo investor of last resort thereby significantly reducing the risk to the

clearing banks that they might be stuck with the collateral. As a consequence,

the PDCF reassured end investors that they could safely keep investing. This,

in turn, significantly reduced the risk that a dealer would not be able to

obtain short-term funding through the tri-party repo system.

Over much of this period preceding the failure of Lehman Brothers, U.S. commercial

banks were relatively insulated from the liquidity run dynamics that plagued

the securities dealers.

This

relative stability was due, in part, to the broad access these commercial banks

had to the Fed’s discount window through the traditional primary credit

facility and through the Term Auction Facility (TAF), which had been introduced

earlier in the crisis in response to liquidity strains in the interbank market. The

fact that most commercial banks relied on insured deposits for significant

portions of their funding was also important. Not only were these insured

deposits stable sources of funding because they were guaranteed by the Federal

Deposit Insurance Corporation (FDIC), but also because they were unsecured;

these deposits freed up collateral that could be used by banks to secure borrowing

from the central bank and elsewhere.

However, once Lehman Brothers failed, many commercial banks and other financial

institutions encountered significant funding difficulties. News that

the Reserve Fund—a large money market mutual fund—had “broken

the buck” due to its holdings of Lehman Brothers paper led panicked investors

to withdraw their funds from money market mutual funds. This caused the

commercial paper market to virtually shut down. This hurt bank holding

companies and other large financial firms that depended on the commercial paper

market for short-term funding.

The result was a widespread loss of confidence throughout the money market

and interbank funding market. Investors became unwilling to lend even

to institutions that they perceived to be solvent because of worries that others

might not share the same opinion. Rollover risk—the risk that

an investor’s funds might not be repaid in a timely way—became

extremely high.

The extreme market illiquidity did not abate until a number of extraordinary

actions were taken by the Federal Reserve and others. For example, the

Federal Reserve introduced the Commercial Paper Funding Facility (CPFF) to

reduce rollover risk in the commercial paper market, the Federal Reserve and

other central banks’ massively expanded the ability of banks to obtain

dollar funding through the TAF and associated foreign exchange swap programs;

the Treasury guaranteed money market mutual fund assets; and the FDIC increased

deposit insurance limits and set up the Temporary Liquidity Guarantee Program

(TLPG) to backstop bank and bank holding company debt issuance.

Having described “what” happened on the liquidity front during

the crisis, I next want to examine, in a bit more detail, “why” it

happened. To do this, I will lay out a simple conceptual framework that I will

then use to assess what can be done to mitigate the risk of such runs occurring

in the future. As a starting point, I will talk about how unsecured

lenders react in a crisis, and then I will consider the behavior of secured

lenders.

Unsecured liquidity providers run for two basic reasons. First, they

run because there is a risk that the company they are lending funds to is insolvent. In

other words, there is a risk that the assets will be worth less than the liabilities,

creating the potential for loss to the creditor. The second reason

that unsecured creditors run is the risk that they will not be repaid in a

timely way. Even if the borrowing firm ultimately turns out to

be solvent, there may be a delay in a lender getting its funds back, and this

delay may prove to be unacceptably costly to the lender.

This second cause of liquidity runs—the risk of untimely repayment—is

significant because it means that expectations about the behavior of others,

or their “psychology”, can be important. This is a classic

coordination problem. Even if a particular lender judges a firm to be solvent,

it might decide not to lend to that firm for fear that others might not share

the same assessment. The less certain any one lender is about the willingness

of other lenders to provide liquidity to a firm, the greater the risk that

too few loans will be extended to prevent liquidation. In that case, even if

the lender turns out to be correct in its judgment of the firm’s solvency,

there still will be a cost in terms of delay in receiving repayment.

A few pictures can help to illustrate these concepts. Figure 1 illustrates

what a creditor’s assessment of the net worth of a financial firm might

look like in normal times. Creditors have uncertainty about what that

value is, thus, the valuation is represented by a probability distribution. The

higher the degree of uncertainty, the greater is the degree of dispersion in

the probability distribution. As long as the probability distribution

is sufficiently far to the right—in other words—well within positive

territory so that there is virtually no risk that the firm is insolvent, lenders

will generally be willing to lend.

So what happens in a financial crisis? First, the probability

distribution shifts to the left as the financial environment deteriorates and

the financial firm takes losses that deplete its capital. Second, and

even more importantly, the dispersion of the probability distribution widens—lenders

become more uncertain about the value of the firm. These two phenomena

are shown together in Figure 2. A lack of transparency in the

underlying assets will exacerbate this increase in dispersion. As the

degree of dispersion widens, a portion of the probability distribution falls

into negative territory. This means that there is a real risk of

loss for unsecured creditors if the firm were forced to liquidate its assets.

Finally, in a crisis, unsecured lenders become more uncertain about others’ assessment

of the probability distribution. For example, if creditor A believes

the probability distribution looks like Figure 1, but at the same time is concerned

that creditor B views the probability distribution as looking like Figure 2,

creditor A may pull back. If there is a risk creditor B and others will

not lend, the firm may not receive sufficient funding. In other words,

even if creditor A believes the firm is solvent, it may not lend because it

does not want to risk a delay in repayment.

So what can creditors do to mitigate these risks? First, they

can respond by charging a higher interest rate in compensation for the increase

in the risk of default. However, there are a number of difficulties

that limit how well this works in practice. Most significantly, by undermining

the firm’s profitability, the higher interest rates may increase the

risk of insolvency. If higher rates push insolvency risk up sharply,

then higher rates may not be sufficient to make lending—even at higher

rates—an attractive proposition.

In addition, some investors such as money market mutual funds may have a very

low tolerance for risk. Thus, they may not be interested in trading off

higher rates as compensation for a non-negligible increase in insolvency risk. Finally,

paying higher rates may generate an adverse signal about the health of the

borrowing institution. This may cause investors to become more worried

about the risk of default.

Second, creditors can secure their lending—taking collateral valued

at more than the amount they lend. However, this is not foolproof because

secured funding can be just as vulnerable to a run dynamic as unsecured funding. For

starters, the same types of uncertainties about the value of the firm may apply

to the liquidation value of the collateral. This is especially

the case if the collateral is lower quality and markets are already illiquid. Moreover,

if creditors are left with the collateral instead of being repaid, fear of

widespread collateral liquidation might further erode collateral values. If

investors respond by seeking more collateral to ensure they will be secured—that

is, that they will be made whole in a liquidation scenario—the firm may

run out of high-quality collateral that the firm can borrow against. This

is a significant risk when a financial firm is highly leveraged and equity

is only a very small proportion of total assets.

The risks of liquidity crises are also exacerbated by some structural sources

of instability in the financial system. Some of these sources are

endemic to the nature of the financial intermediation process and banking. Others

are more specific to the idiosyncratic features of our particular system. Both

types deserve attention because they tend to amplify the pressures that lead

to liquidity runs.

Turning first to the more inherent sources of instability, there are at least

two that are worthy of mention. The first instability stems from

the fact that most financial firms engage in maturity transformation—the

maturity of their assets is longer than the maturity of their liabilities. The

need for maturity transformation arises from the fact that the preferred habitat

of borrowers tends toward longer-term maturities used to finance long-lived

assets such as a house or a manufacturing plant, compared with the preferred

habitat of investors, who generally have a preference to be able to access

their funds quickly. Financial intermediaries act to span these preferences,

earning profits by engaging in maturity transformation—borrowing shorter-term

in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more

slowly than its liabilities, it does not have the option of simply allowing

its assets to mature when funding dries up. If the liabilities cannot

be rolled over, liquidity buffers will soon be weakened. Maturity transformation

means that if funding is not forthcoming, the firm will have to sell assets.

Although this is easy if the assets are high-quality and liquid, it is hard

if the assets are lower quality. In that case, the forced asset sales are likely

to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are

typically worth much more as going concerns than in liquidation. This

loss of value in liquidation helps to explain why liquidity crises can happen

so suddenly. Initially, no one is worried about liquidation. The

firm is well understood to be solvent as shown in Figure 1. But once

counterparties start to worry about liquidation, the probability distribution

can shift very quickly toward the insolvency line, as shown in Figure 2, because

the liquidation value is lower than the firm’s value as a going concern.

There are also a number of idiosyncratic sources of instability worthy of

mention, some of which are unique to our particular system. One source

of instability is the tri-party repo system that I discussed earlier. Another

is the convention of tying collateral calls to credit ratings. In this

case, if a firm’s credit rating is lowered, the firm may have to post

additional collateral to its counterparties, eliminating this collateral as

a potential source of funding. This phenomenon was a particularly important

problem for AIG, which lost its access to the commercial paper market and was

subject to increased collateral calls. Both factors caused the liquidity

of the AIG parent company to be depleted very quickly. Finally, if asset

volatility rises, haircuts can increase. This can lead to haircut spirals

in which higher haircuts lead to forced asset sales, increased volatility and

still higher haircuts.

These sources of instability create the risk of a cascade—of firms moving

rapidly from the situation represented in Figure 1 to that shown in Figure

2. Once the firm’s viability is in question and it is does not

have access to an insured deposit funding base, the next stop is often a full-scale

liquidity crisis that often cannot be stopped without massive government intervention.

Fortunately, there are ways to mitigate the risk of a cascade. First,

we can require that financial intermediaries hold more capital. This

would push the probability distribution to the right in Figure 2. With

sufficient additional capital, the probability of insolvency could be reduced

to a low enough level that liquidity providers would not run.

Higher capital requirements work to reduce the risk of liquidity runs, but

potentially at the cost of making the process of financial intermediation much

more expensive. In particular, a requirement that firms must hold more

capital increases intermediation costs. Moreover, banks may respond to higher

capital requirements by taking on greater risk. If an increase in risk-taking

were to occur, the movement of the probability distribution to the right in

Figure 2 might be offset by an increase in the degree of dispersion. Thus,

higher capital requirements might not necessarily be sufficient to push all

of the probability distribution above zero.

Second, regulators could require greater liquidity buffers. These

buffers would help protect the firm against having to liquidate assets under

duress, and would therefore help prevent the probability distribution from

sliding left toward the zero line in Figure 2. But there is a

cost to the firm from holding greater liquidity buffers in terms of lower returns

on capital. So, requiring greater liquidity buffers would also tend to

drive up intermediation costs. And, just as in the case of higher

capital requirements, banks could respond by taking greater risks.

Third, regulators could implement changes that would reduce the degree of

dispersion in the potential value of a firm, pushing the right tail of the

distribution in Figure 2 to the left. For example, we could require greater

transparency about the composition and quality of the firm’s assets and

liabilities. Or, regulators could increase transparency by forcing greater

disclosure of the sale price of assets and/or by pushing for greater homogeneity

and price discovery for products such as OTC derivatives. We could

improve the quality of regulation and supervision, which would increase confidence

in regulatory measures of capital and financial firms’ soundness.

Fourth, the central bank could provide a liquidity backstop to solvent firms. For

example, the central bank could commit to being the lender of last resort as

long as it judged the firm to be solvent and with sufficient collateral. This

would reduce the coordination problem and the risk of panics sparked by uncertainty

among lenders about what other creditors think. If the central bank

is willing to provide backstop liquidity, then a lender that judges the financial

firm to be solvent should be willing to lend. The backstop liquidity ensures

timely repayment. The lender of last resort role eliminates the externality

in which the expectations about the willingness of one lender to lend influences

the decisions of others.

However, providing a liquidity backstop is not without its own set of problems. If

firms have liquidity backstops that are viewed as credible, then this creates

moral hazard. Firms do not have to worry as much about what lenders think

about their capital adequacy or the size of their liquidity buffers. This

creates incentives to run leaner in terms of capital and liquidity, which increases

the risks to the backstop liquidity provider.

To mitigate such effects, the backstop liquidity provider could presumably

charge financial firms for the value of the backstop. But what fee would

be appropriate? It is difficult to assess the probability of financial panics

and the value of backstop liquidity facilities.

Fifth, regulators could take steps to reduce the difference between the value

of the firm dead versus alive. For example, we could improve the resolution

process so that less of a firm’s value is destroyed by the liquidation

process. If we could reduce the difference in value between a firm as

a going concern versus the same firm in liquidation we could reduce the severity

of the cascade effect when financial conditions deteriorate.

Sixth, we could make structural changes to the financial system to make it

more stable in terms of liquidity provision. For example, consider the

three structural issues outlined earlier that amplified the crisis—tri-party

repo, collateral requirements tied to credit ratings, and haircut spirals. In

the case of tri-party repo, the amplifying dynamics could be reduced by enforcing

standards that limited the scope of eligible collateral or required more conservative

haircuts. Formal loss-sharing arrangements among tri-party repo borrowers,

investors, and clearing banks might reduce or eliminate any advantage that

might stem from running early. Eliminating the market’s reliance

on intraday credit provided by clearing banks could eliminate the tension between

the interests of clearing banks and investors when a dealer becomes troubled. In

the case of collateral requirements, collateral haircuts could be required

to be independent of ratings.

Many of these suggestions are already in the process of being implemented. For

example, the Basel Committee is in the process of strengthening bank capital

in four ways: 1) higher capital requirements; 2) higher quality capital;

3) more complete risk capture; and 4) capital conservation measures, including

the use of contingent capital instruments. With greater capital

buffers, the risk of liquidity runs should be reduced going forward. It

should be noted, however, that use of contingent capital instruments, or any

other potential changes to our current capital regime, does not obviate the

need for an improved resolution process.

Second, the Basel Committee is moving forward with its work in establishing

liquidity standards for large, complex financial institutions. These

liquidity standards would consist of two parts. First, there would be

a liquidity buffer made up of high-quality liquid assets that would be of sufficient

size so that the firm could manage a stress event caused by a short-term loss

of investor confidence. Second, there would be rules concerning the degree

of allowable maturity transformation. Long-term illiquid assets would

have to be largely funded by equity and longer-term borrowing, not by short-term

borrowing, such as tri-party repo.

Third, the Federal Reserve is working with

a broad range of private sector participants, including dealers, clearing banks,

and tri-party repo investors to eliminate the structural instability of the

tri-party repo system so that tri-party borrowers are less vulnerable

to runs. Exactly

how the mechanics of the tri-party repo system will be adjusted is still a

work in process.

Fourth, the major U.S. securities dealers are now subject to supervision by

the Federal Reserve under the Bank Holding Company Act. This means that

their liquidity funding needs are subject to supervisory oversight, including

stress tests, to ensure that the firms can meet large funding drains.

Liquidity risk will never be eliminated, nor should it. The preferences

of borrowers to borrow long and of lenders to lend short means that the maturity

transformation process generates real benefits. However, we can do better

to make our system less prone to the types of liquidity runs that we have experienced. If

we remain committed to implementing the reforms that are already underway,

I am confident that we can dramatically reduce the risks of the type of liquidity

crises that we experienced all too recently.

Thank you for your kind attention. I would be happy to take a few questions.

__________________________________________

The collapse of the shadow banking system, in turn, put intense pressure on commercial banks. Off-balance- sheet items came back on to bank balance sheets and the quality of bank assets fell sharply. The end result was a sharp tightening in the availability of credit that served to exacerbate the downward pressure on economic activity.

Some dealers were further weakened by having provided significant amounts of funding to failed investment funds, which reduced the amount of funding that was available to meet other needs.

One final factor that was important in exacerbating the funding crises was the novation of over-the-counter (OTC) derivative exposures away from a troubled dealer. In a novation, a customer asks a different dealer to stand in between the customer and the distressed dealer. This process results in the outflow of cash collateral from the distressed dealer. The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.

There were funding strains prior to the Lehman Brothers failure and these were most apparent in the elevated spreads evident in term LIBOR funding compared with the federal funds rate.

Moreover, certain classes of investors such as money market mutual funds do not take much comfort in collateral. Also, the headline risk of having exposure to a troubled participant could subject investors such as money market funds to liquidity pressures of their own. Investors could withdraw funds before losses are realized.

This problem has been largely addressed in the banking sector by deposit insurance and by providing access to lender of last resort facilities. In addition, supervisory and reporting requirements address transparency issues.

Supervision could also be brought to bear to limit the tendency for firms to reduce their capital and liquidity when provided with a credible liquidity backstop.

Work is also underway to shift the settlement of OTC derivative trades to central counterparties (CCPs). This is important because CCPs reduce risk exposures by netting out the offsetting exposures among the CCP participants. Also, because the counterparty risks move to the CCP rather than staying with the individual dealers, the incentive to novate—move trades away from troubled dealers—is reduced.

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