Managing Crises without Government Guarantees—How Do We Get There? - FEDERAL RESERVE BANK of NEW YORK
Speech
Managing Crises without Government Guarantees—How Do We Get There?
October 3, 2011
Posted October 26, 2011
Christine M.
Cumming
, First Vice President
Remarks at Banking Law Symposium 2011, Paris, France
Good afternoon. I want to thank the conference organizers for inviting
me to this very timely and relevant conference. I will be expressing
my own views, and not those of the Federal Reserve System or the Federal Reserve
Bank of New York.
The times are extraordinary, and the conference agenda reflects
it. The years of financial turbulence that we have experienced and continue
to experience have illuminated both the power and the limitations of government
intervention in managing financial crises. These years have illustrated how
much more we need to understand about good design principles for intervention
and sound strategies for the restoration of financial and banking market function
following a crisis. And these years have highlighted the interaction between
the fiscal condition and capacity of countries and the size and health of the
domestic financial system. The conference agenda touches on all of these.
I
speak of government intervention broadly, because the answer to the provocative
question I am to discuss—how can we conduct crisis management without
financial guarantees—depends a great deal on which types of government
intervention we hope to avert. Certain guarantee or contingent arrangements
can short-circuit incipient instability or stabilize already roiled financial
institutions and markets; we do not want to end them. Other interventions
are more intrusive and involve more socialization of loss; we want to reduce
their necessity.
Guarantee has a legal meaning—for example, the Federal
Reserve is not authorized to issue a guarantee—but I will use the word
more broadly to describe contingent arrangements. Definitions of guarantee
are variations of: "a warrant, pledge, or formal assurance given as
security that another's debt or obligation will be fulfilled"; in the
financial sector, that primarily means credit risk protection.
Guarantees,
insurance and options have similar structures. They are contingent, they have
prices and triggers, and the payout is meant to cover a specific risk. Because
guarantees, like insurance, change the risks to the guaranteed party and its
creditors, both third-party guarantees and insurance can change the affected
parties' behavior in an adverse way,
and therefore create moral hazard. Thus, the provision of a guarantee
also involves various control activities—underwriting, monitoring, imposing
penalties for deviation from terms—intended to correct those incentives.
The cost of the guarantee therefore is not only the cost of hedging and absorbing
credit risk, but also the costs of control activities and an adjustment for
any social efficiency gains or losses.
One reason that I draw the connection
between guarantees, insurance and options is that the theory and technique
for valuing insurance and options have advanced substantially in the last three
decades. Thus, guarantees can in concept be valued. I stress "in concept" because
those valuation efforts are still approximate. But the measures show promise.
For example, Deborah Lucas and Robert L. McDonald in a 2006
Journal of
Monetary Economics
paper used a "stress value at risk" measure
to capture the risk in the implicit government guarantee to Fannie Mae and
Freddie Mac and obtained values that indicated the large and growing risk of
those institutions. The value of a guarantee, even an approximation of its
value, provides a potentially powerful signal of risk to the financial authorities.
Let me now turn to the U.S. experience during the recent financial crisis
to describe an approach to characterizing the spectrum of government interventions.
The U.S. Experience with Intervention During the 2008-09 Financial Crisis
Of course, no one can do justice in a few minutes to the unprecedented central
bank and government interventions during the 2008-09 financial crisis. Fortunately,
much information is available on the internet; for example,
www.federalreserve.gov
contains
a section called "Credit and Liquidity Programs" with a wealth
of detail on the Fed's actions during the crisis.
The United States employed four
major types of interventions in the financial crisis. The first interventions
were expanded programs providing liability insurance. The Federal Deposit Insurance
Corporation (FDIC) raised the standard deposit insurance coverage limit. The
FDIC established a Temporary Liquidity Guarantee Program with two arms—a
transaction (checking) account program that effectively covered corporate deposits
and a debt guarantee program that covered unsecured short- and medium-term
financial company debt. In addition, the U.S. Treasury offered insurance for
money market mutual funds to curb "run risk" in
those funds.
The second interventions were the market liquidity facilities provided
by the Federal Reserve. While the Fed has authority to lend on a collateralized
basis to banks, a large proportion of U.S. short- and medium-term funding
for financial and nonfinancial firms now occurs in markets. The triparty
repo market finances securities holdings for broker-dealers; the commercial
paper market provides working capital for corporations; the asset-backed commercial
paper and securities markets fund receivables and loans arising in business
activities.
Under section 13(3) of the Federal Reserve Act, in unusual and
exigent circumstances, the Federal Reserve can make loans to nonbank borrowers.
As funding markets came under duress in 2008 and 2009, the Federal Reserve
acted in a series of these markets. The common problem in each market was concern
that an obligation would not be repaid at maturity because the obligor might
experience either credit problems or liquidity constraints.
The interesting "contingent" aspect
of these liquidity facilities was the pricing. The price, expressed as a borrowing
rate, was set to stand well above the interest rates that prevailed prior to
the crisis, but well below the rates then posted in strained markets. The pricing
created a dynamic in which the availability of the facility eased funding pressures,
borrowing rates in that market began to fall, and as markets gradually normalized,
the market rate eventually fell below the rate charged by the Federal Reserve.
With that fall in the market rate, borrowing tailed off and the facility gradually
wound down. The volume of transactions in the facility and the market
pricing gave the Federal Reserve—and market participants—insight
into the program's impact and the market's recovery.
The third interventions
were more firm specific: loans and other support to AIG, assistance to the
Bear Stearns merger and an asset guarantee program announced for two financial
institutions and implemented for one. The fourth and most well-known interventions
were the capital injections in financial firms using funds from TARP, the U.S.
government's Troubled Asset Relief Program.
These various interventions
can be arrayed along two dimensions. The first is the nature and extent of
loss absorption inherent in the design of the intervention—just how much "tail" or
catastrophe risk the government is taking on. For deposit insurance arrangements,
long experience suggests that the cost of the "tail" of losses
during even a very distressed period is low relative to the benefits of prevention
of runs and contagion. Similarly, the Fed's market liquidity facilities
were meant to provide a backstop for market funding, predicated on the soundness
of the underlying collateral assets and their margining. Moreover, both
types of programs required little upfront investment of cash. In contrast,
the direct loan to AIG, while collateralized, and the TARP investments involved
substantial risk-taking and massive funding.
The second dimension is the economic
cost of the intervention—just how
intrusive the intervention is. All forms of intervention require some
kind of underwriting, monitoring and enforcement, and many distort private
market incentives and function, as I noted earlier. Ideally, I would
include measures of both administrative costs and economic distortion in total
cost.
Each intervention involved administrative burdens of varying
extent. The FDIC's and Treasury's liability insurance programs
rested largely on the existing licensing and supervision of regulated financial
companies. The Federal Reserve's liquidity facilities rested on eligibility
standards for borrowers and collateral, with a heavy reliance on the existing
market infrastructure and processes for controls. By contrast, the firm-specific
interventions required significant firm and examiner resources and extensive
new financial controls. The TARP capital injections involved not only
statutory constraints, most notably on executive compensation, but also a high
level of scrutiny through public reports by the Congressional Oversight Panel
and the Special Inspector General for TARP.
There are actual and potential
programs that fall between the poles on both dimensions. The Term Asset-Backed
Securities Loan Facility (TALF) created by the Federal Reserve to restart asset
securitization markets lent to investors against asset-backed securities for
terms of three and five years. Arguably, the Fed took on more risk of loss
with the term of the loan, its non-recourse nature, and the type of collateral
than it did in its other facilities. For that reason, TALF was complemented
by arrangements for any work-out of defaulted collateral and was supported
by TARP funding. On the administrative side, both borrowers and collateral
had to meet eligibility requirements; the Federal Reserve Bank of New York
extensively reviewed potential collateral and conducted compliance reviews
at dealers arranging TALF borrowing.
The types of interventions for any given
country will reflect its financial system structure and its institutional setting.
The U.S. approach reflected the heavy reliance on markets and nonbanks for
financing specific to our financial system. In addition, judgments about how
much government loss absorption and intrusion are appropriate in central bank
and government interventions will reflect country-specific circumstances and
preferences.
As a final note, what didn't work well in the U.S. experience
were implicit guarantees—that is, assumptions that the government would
protect holders of certain liability and equity instruments that had no explicit
guarantee. Official actions that laid bare the absence of the explicit guarantee—the
imposition of losses on equity and subordinated debt investors when Fannie
Mae and Freddie Mac were taken into conservatorship and on senior unsecured
bondholders in the resolution of Washington Mutual—contributed to the
dynamic of escalating panic in Fall 2008. Each action was one more shock at
the time, but the investors' shock also pointed to the lack of hoped-for
monitoring and market discipline by debt and equity investors in the run up
to the crisis.
Contingent Arrangements and Financial Institution Failure
Guarantees as I described them earlier are about protection against failure
to meet financial obligations, that is, against default and insolvency. The
alternative to escalating government intervention during the crisis was accepting
a higher rate of financial institution insolvencies. The consequences
of multiple failures of large, complex and international organizations were
largely unknowable. They included the likelihood of disruption of systemically
important financial activities (such as payment services, where the customer
need is immediate and customers cannot quickly switch to another provider)
and the almost certain contagion to other institutions. The September
2008 bankruptcy of Lehman Brothers Holdings, Inc., underscored the difficulty
of controlling the ramifications of the failure of just one large cross-border
institution and the cost, complexity and extreme inefficiency of the existing
cross-border insolvency process.
The "too big to fail" problem—the
expectation that a large financial institution insolvency would be too disorderly
and too destructive of wealth for financial authorities to risk—has frustrated
financial authorities, legislators, and academics since at least the failure
of Continental Illinois Bank in 1984. In the wake of the crisis, the frustration
is now shared by the public. Having intervened so forcefully in the
crisis, financial authorities and others also worry that moral hazard has increased
as a result.
An important avenue to tackle the too-big-to-fail problem
is to improve the feasibility of cross-border resolution of large financial
firms. The Financial Stability Board (FSB) in 2009 commissioned work on improving
the process for cross-border resolution of systemically important financial
institutions. The work since then is reflected in a set of proposed principles
published for consultation by the FSB in July 2011,
Key Attributes of Effective
Resolution Regimes.
The
Key Attributes
paper is more than a
set of principles or emerging standards; the paper also maps out a series of
actions to be taken in order to improve the feasibility of resolving a systemically
important financial firm. The goal is to take actions that ease and speed the
resolution of the largest firms while preserving critical functions and reducing
the contagion and destruction of value that occurs in liquidation and, most
important, to do so without recourse to public funds that exposes taxpayers
to risk of loss.
The FSB proposes that all jurisdictions have a set of resolution
powers, among them, the ability to create a bridge or similar institution,
into which the healthy parts of a financial firm, including its critical activities,
can be placed. In addition, the resolution authority needs the power to transfer,
sell and restructure all or part of the firm. These powers have been
used successfully by the FDIC in the United States, and a number of jurisdictions
have adopted or have plans to adopt similar powers. The increased international
use of bridge institutions is likely to require jurisdictions to recognize
bridge banks from other countries, in order that some business functions, such
as payment activities, can seamlessly transition to the successor bridge institution.
The
bridge institution concept is quite powerful. The FDIC recently published a
paper in its
Quarterly
that described how it could have handled
the Lehman bankruptcy using its new powers under the Dodd-Frank Act to resolve
systemically important nonbank financial institutions. The FDIC outlines
how it could have created a bridge institution for the Lehman holding company,
how it could have transferred to the bridge Lehman's equity holdings
in its key subsidiaries, including its major broker/dealers, potentially avoiding
their insolvency, and how it could have funded the London broker/dealer, a
key problem following Lehman Holdings' bankruptcy in New York. Selling
the broker/dealer subsidiaries as going concerns would preserve far more of
their value and continuity of operations, as illustrated by the sale of most
of Lehman's U.S. broker/dealer, which did not immediately enter insolvency.
The
FDIC's article offers a promising path toward a workable cross-border
insolvency process, a potential solution to a daunting problem, especially
when viewed against the meaningful, but small progress made in the efforts
of the past two decades. To build out the FDIC's proposed path
to a workable cross-border insolvency process requires conforming changes to
laws and rules across most jurisdictions. I do not want to minimize the
challenges in developing the approach further, but simply highlight its potential
to ameliorate a problem we would all like solved.
The FSB also proposes to
make the process of recovery planning by firms and resolution planning by financial
authorities an important principle. This planning, already underway for many
systemically important financial firms, is being carried out by firm-specific
crisis management groups, made up of regulators and resolution authorities
from the jurisdictions where a given firm has its principal operations. The
FSB also sets a broad direction for involving and communicating with host country
jurisdictions where the host authorities view the financial firm to be of local
systemic importance.
The FSB further proposes that the home country authorities,
collaborating and coordinating with the crisis management group, produce an
annual resolvability assessment. This assessment would identify a set of impediments
to resolution and provide a list of follow-up actions, potentially some for
the firm, but also some for the jurisdiction. Progress on the follow-up actions
would be assessed in the following year.
The stated goal of the FSB's work is
to make possible the resolution of systemically important financial institutions
without exposing taxpayers to risk of loss. That will not happen overnight.
In my view, we should be striving year by year to improve the feasibility and
possibility of cross-border resolution. That means a dynamic assessment process
that seeks improvement against the current baseline and addresses key changes
in the firm and in the industry that either facilitate or complicate resolution.
A stronger, more common resolution framework, a meaningful resolution planning
process, and an annual resolvability assessment to ensure progress should make
resolution a stronger alternative to government intervention.
Final Thoughts on Crisis Management Without Government Guarantees
Financial authorities are never really out of the crisis management business.
The recent U.S. experience with crisis has illuminated vulnerabilities in the
U.S. financial system, such as the role and structure of the government sponsored
enterprises (GSEs), Fannie Mae and Freddie Mac, and the need for reform in
the triparty repo market and the money market mutual fund sector.
The systematic
search for such points of vulnerability and new ones should be an important
and permanent part of the work at the domestic and the international levels
by financial authorities. What we need in the financial system is defense
in depth, a series of actions both macro- and micro-prudential, that help
prevent crises and help us manage them more effectively when they occur.
The preventive measures include the new proposed Basel rules on capital and
liquidity, intended to make financial institutions more resilient, especially
systemically important firms; the international effort to strengthen the
market infrastructure and supervisory oversight of financial derivatives;
in the United States, the extension of comprehensive supervision to systemically
important nonbank financial firms; and our ongoing efforts to reform the GSEs,
the triparty repo market and the structure of money market mutual funds.
So let me conclude
with some thoughts on the question of how close we might get to crisis management
without government guarantees. For me, the paradigm of managing crises was
the U.S. response in the early 1990s to its real-estate and leveraged buyout
problems; while smaller than the more recent problems, the potential losses
then threatened to engulf some of our largest banks. The paradigm consisted
of three interconnected elements: identifying and isolating the problem assets
for dedicated work-out management; replenishing the capital and liquidity of
the firm; and drawing up new and credible business plans demonstrating the
future profitability of the firm. The supervisors sought to be pre-emptive
and proactive—propelling firms to acknowledge
problems and take actions earlier than they might otherwise would have.
Where
this paradigm was applied, we avoided failure. That experience illustrates
that there is no substitute for early intervention in preserving value in the
firm and in limiting externalities and other spillovers. Early intervention
calls for strong supervisory oversight, as envisioned by the Basel Committee
on Banking Supervision. It is significant that the FSB's
Key
Attributes
paper on resolution highlights the important role of recovery
planning by firms. Recovery planning and the dialogue with and among
supervisors that accompanies it should facilitate early intervention. The
recovery plan will already be on paper and the supervisory dialogue begun even
before the firm starts to experience difficulty.
Early intervention will also
be essential in resolution if recovery efforts fail. The
Key Attributes
highlights
the need for resolution authorities to be able to act before technical insolvency.
Resolution planning should once again facilitate that difficult decision to
place a firm into an insolvency proceeding when it is necessary.
Second, government
intervention measures such as those I described at the outset cannot substitute
for the hard work that goes on in a private restructuring or in resolution.
For example, even after the passage of a massive TARP fund and the injection
of capital into the largest banks, market pressures continued for some banks,
and those pressures only eased with more intervention, the thorough Supervisory
Capital Assessment Program, also called the stress tests, for which results
were disclosed, and a plan for specific capital actions by some firms. Problems
need to be identified, capital and liquidity raised, new business plans put
in place and old ones abandoned. Delays in taking and executing these hard,
for the firm often life-changing, decisions contribute to the necessity for
further intervention.
Third, I believe having some types of contingent arrangements
in reserve will continue to be necessary, even with much a much stronger cross-border
resolution process. The role of deposit insurance in stemming financial crises
is well documented. A period of multiple financial institution failures,
even with a strong resolution process, might trigger the same risk aversion
in funding markets that we saw in 2008 and 2009. The ability to backstop
key funding markets could prove valuable, and the Dodd-Frank Act preserved
for the Fed authority under 13(3) to provide market liquidity facilities even
while eliminating other aspects. But in designing these interventions,
an exit strategy needs to be clear. Leaving those arrangements in place
too long distorts incentives and erodes private market function.
And for those
contingent arrangements that are ongoing, such as deposit insurance, measuring
the value of the guarantee could be an important test of overall design of
the guarantee and the accompanying monitoring regime. Continuing to refine
our ability to value guarantees would provide a useful measure for supervisory
authorities and for the deposit insurers, especially when they consider changes
to deposit insurance. The value of guarantees also would complement other measures
being developed for financial stability monitoring. Further, I suggest that
all guarantees should not only be measured, but documented and reported, and
not left as implicit.
Fourth, it will still be important to have a set of progressive
actions that government can turn to if human judgment or the tools available
at a time of incipient financial crisis prevent financial authorities from
defusing the crisis. While such measures buy time and cannot substitute for
more permanent solutions, sometimes time
is
the scarce resource.
Deterioration in financial conditions--at individual financial institutions
and in the economy—is inevitable as a crisis wears on in a financial system,
given its leverage. Understanding that, financial authorities should feel great
urgency to apply the progressive measures when they are needed, doing so with
the force and size that truly arrest the crisis forces, and to entertain the
usually difficult measures needed to resolve the fundamental problems behind
the crisis.
Thank you.
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