In a speech Friday, "More Lessons from the Crisis," at the Center for Economic Policy Studies (CEPS) Symposium in Princeton, Federal Reserve Bank of New York President and CEO William C. Dudley discussed "the extraordinary liquidity events that played out during this crisis." He described "how funding dried up rapidly for firms such as Bear Stearns, Lehman Brothers, and AIG" and suggested "some concrete steps we might take toward making the financial system more resilient -- cautioning that there are no magic bullets."

Dudley says, "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.... 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."

He continues, "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."

Dudley comments, "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.... 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."

He adds, "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.... The extreme market illiquidity did not abate until a number of extraordinary actions were taken by the Federal Reserve and others [including] the Commercial Paper Funding Facility (CPFF) ... 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)."

He concludes, "Fortunately, there are ways to mitigate the risk of a cascade. First, we can require that financial intermediaries hold more capital.... Second, regulators could require greater liquidity buffers.... Third, regulators could implement changes that would reduce the degree of dispersion in the potential value of a firm.... 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."

Finally, Dudley says, "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 ... [and is] moving forward with its work in establishing liquidity standards for large, complex financial institutions.... [T]he 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." But he adds, "Liquidity risk will never be eliminated, nor should it."

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