Lessons Learned from the Financial Crisis - FEDERAL RESERVE BANK of NEW YORK
Speech
Lessons Learned from the Financial Crisis
June 26, 2009
Posted July 3, 2009
William C.
Dudley
, President and Chief Executive Officer
Remarks at the Eighth Annual BIS Conference,
Basel, Switzerland
In assessing the lessons of the past two years, I will focus on five broad
themes that are interrelated:
Interconnectedness of the financial system
System dynamics—How does the system respond to shocks?
Incentives—Can we improve outcomes by changing incentives?
Transparency
How should central banks respond to asset bubbles?
As always, my views are my own and may not necessarily reflect those of the
FOMC or the Federal Reserve System.
Interconnectedness
This financial crisis has exposed how important the interconnections are among
the banking system, capital markets, and payment and settlement systems. Focus
on only one part of the financial system can obscure vulnerabilities that may
prove very important. For example, the disruption of the securitization
markets caused by the poor performance of highly-rated debt securities, led
to significant problems for major financial institutions. Banks had to
take assets back on their books; backstop lines of credit were triggered; and
banks could no longer securitize loans, increasing the pressure on their balance
sheets. This reduced credit availability, which increased the downward
pressure on economic activity, which caused asset values to decline further,
increasing the degree of stress in the financial system.
The high degree of
interconnectedness across the financial system has a number of implications. First,
supervision must not just be vertical—firm
by firm, or region by region, but also horizontal—looking broadly across
banks, securities firms, markets and geographies.
Second, this means that supervisory practices need to be revamped. They
need to be coordinated and multi-disciplinary. I think the U.S. Treasury
is right in proposing a systemic risk regulator as part of their regulatory
reform plan. But, we shouldn’t kid ourselves about how difficult
this will be to execute. You will need a flexible and dynamic
governance process to be able to identify the important elements of systemic
risk, to elevate those concerns to the appropriate level and then to act on
those concerns in a timely manner. It will take the right people, with
the right skill sets, operating in a system with the right culture and legal
framework. I don’t believe creating this oversight process will
be an easy task. Consider, for example, subprime lending. There
were obvious excesses in terms of underwriting standards, product design and
risk management. But addressing those issues during the boom would have
required the supervisor to absorb attacks that reining in some of these practices
would make it more difficult for some low- and moderate-income households to
become homeowners for the first time.
System Dynamics
In thinking about interconnectedness, we also need to focus on system dynamics. By
system dynamics, I mean how the different parts of the system interact. Do
they interact in a way that dampens a shock or in a way that intensifies it? To
the extent that the system has important reinforcing rather than dampening
mechanisms, then it may need to be modified. That may require significant
re-engineering.
Let me give you some examples of reinforcing and dampening mechanisms:
Capital. When
firms have incentives to continue to pay dividends to show they are strong
that is a reinforcing or amplifying mechanism. The
paying of the dividends depletes capital, making the firms weaker. In
contrast, when firms have incentives (or are forced) to cut dividends quickly
to conserve capital, that is a dampening mechanism.
Foreign exchange. When
the debts of a country held by foreigners are denominated predominantly in
the home currency, currency depreciation reduces the net debt burden—the
value of foreign assets climbs relative to the asset claims of foreigners.
The U.S. operates in a dampening regime in this respect. In contrast, when
the debts of the home country are denominated in foreign currency, currency
depreciation increases the net debt burden. Some of the Baltic countries
are wrestling with this dilemma currently.
Some reinforcing mechanisms that we might want to engineer out of the financial
system:
Collateral tied to credit ratings. Credit downgrades lead to increased
collateral calls which drains liquidity, leads to forced asset sales, further
weakening the firm subject to the collateral calls. I don’t have
any great ideas on how to address this, but it is a problem that needs to
be fixed.
Collateral and haircuts. When volatility rises and that leads to
increased haircuts, the result can be a vicious cycle of forced asset sales,
higher volatility and still higher haircuts.
Compensation tied to short-term revenue generation, rather than long-term
profitability over the cycle. This causes risk-takers to take on too
much risk because they are compensated on the upside. This extends
the boom.
Incentives
Incentives may be very important in determining whether we have a system that
is dampening rather than amplifying. I think bad outcomes are not just
about bad luck, they are also about bad incentives. The problem
with incentives may be due to faulty compensation schemes, poor risk management
or the fact that participants do not bear the full costs of their actions.
One problem that we had in the U.S. banking system over the past year was
a reluctance of banks to raise sufficient capital to be able to withstand bad
states of nature. They didn’t want to do this because this might
unnecessarily dilute their shareholders. As a result, many banks did
not hold sufficient capital and market participants knew this. This led
to tighter financial and credit conditions, which made the bad state of the
world more likely. This is an example of both bad incentives and an amplifying
mechanism.
The Supervisory Capital Assessment Program (SCAP) exercise that we undertook
in the United States leaned against this. By forcing all the banks to
have sufficient capital to withstand a stress environment, we increased the
likelihood that all the big banks would be able to survive a stress environment.
This generated an improvement in confidence and a willingness of banks to engage
with each other. This also made it easier for banks to be able to tap
the capital markets. The SCAP exercise made a bad state of the world
outcome less likely, helping to create a virtuous circle rather than a vicious
one. The SCAP exercise was conducted on an
ad hoc
basis. It
probably would be much better to figure out how to do these types of exercises
on a systematic basis. Such exercises may need to be hardwired into the
oversight of the financial system.
Capital requirements are one area where I think we could adjust the rules
in a way to improve incentives. For example, imagine that we mandated that
banks had to hold more capital, but that the added capital could be in the
form of a debt instrument that only converted into equity if the share price
fell dramatically. What would this do? It would change management’s
incentives. Not only would management focus on generating higher stock
prices, but they would also worry about risks that could cause share prices
to fall sharply, resulting in dilution of their share holdings.
Debt convertible into equity on the downside would also be helpful in that
it would be a dampening mechanism—equity capital would be automatically
replenished, but only when this was needed.
Transparency
There were many areas where a lack of transparency contributed to a loss of
confidence, which intensified the crisis. One particular area was the
case of over-the-counter securities such as ABS, CMBS, RMBS and CDOs and their
associated derivatives.
There was a lack of transparency in a number of different dimensions.
A.
Valuation. CDOs and other securitized obligations were complex and
difficult to value. This reduced liquidity, pushed down prices and created
increased uncertainty about the solvency of institutions holding these
assets.
B.
Prices. The lack of pricing information led to a loss of
confidence about accounting marks. Sometimes identical securities were
valued differently at different financial institutions.
C.
Concentration of risk. Because there was no detailed reporting
of exposures, market participants did not know much about the concentration
of risk. This led to a reluctance to engage with counterparties, which,
in turn, pushed up spreads and reduced liquidity further.
The SCAP exercise was an example where increased transparency helped to generate
a better outcome. We disclosed our stress test methodology and the results
for each of the nineteen largest bank holding companies. This transparency
increased confidence and made it easier for the banks to raise more capital.
Monetary Policy and Asset Bubbles
In my opinion, this crisis should lead to a critical reevaluation of the view
that central banks cannot identify or prevent asset bubbles, they can only
clean up after asset bubbles burst.
As I wrote in 2006, this orthodoxy can be summarized by three propositions:
1.
Asset bubbles are hard to identify.
2.
Monetary policy is not well-suited to respond to bubbles.
3.
Thus, the cost/benefit tradeoff of “leaning against
the wind” against asset bubbles is unfavorable.
From these propositions, the two important policy implications directly follow:
1.
The central bank should only take asset bubbles
into consideration in the conduct of monetary policy to the extent that
these asset bubbles affect the growth/inflation outlook.
2.
The monetary authorities should be there to “clean-up” after
bubbles burst, both to prevent systemic problems and undesired downward
pressure on economic activity and/or inflation.
Relative to this, I would argue that:
1.
Asset bubbles may not be that hard to identify—especially
large ones. For example, the housing bubble in the United States had been
identified by many by 2005, and the compressed nature of risk spreads and
the increased leverage in the financial system was very well known going
into 2007.
2.
If one means by monetary policy the instrument of short-term
interest rates, then I agree that monetary policy is not well-suited to
deal with asset bubbles. But this suggests that it might be better for
central bankers to examine the efficacy of other instruments in their toolbox,
rather than simply ignoring the development of asset bubbles.
3.
If existing tools are judged inadequate, then central banks
should work on developing additional policy instruments.
Let’s take the housing bubble as an example. Housing prices
rose far faster than income. As a result, underwriting standards deteriorated. If
regulators had forced mortgage originators to tighten up their standards or
had forced the originators and securities issuers to keep “skin in the
game”, I think the housing bubble might not have been so big.
I think that this crisis has demonstrated that the cost of waiting to clean
up asset bubbles after they burst can be very high. That suggests we
should explore how to respond earlier.
Harkening back to my earlier themes, I think we can respond in a number of
ways:
First, we can do a better job understanding interconnectedness. This
means changing how we oversee and supervise financial intermediaries.
Second,
we can change the system so that it is more self-dampening.
Third, we can
improve incentives.
Fourth, we can increase transparency.
Fifth, we can develop additional
policy instruments. For example, we might give a systemic risk regulator
the authority to establish overall leverage limits or collateral and collateral
haircut requirements across the system. This would give the financial authorities
the ability to limit leverage and more directly influence risk premia and
this might prove useful in limiting the size of future asset bubbles.
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