"What the Fed Did and Why"
The New York Federal Reserve Bank's Exec. V.P. Joseph Tracy spoke last week on "What the Fed Did and Why". He commented on "The Panic of 2007," "I would like to look back over the events of the past several years and offer my perspective on what were the essential drivers of the financial crisis and the Federal Reserve’s interventions.... The first question to explore is the extent to which the financial system had evolved over the past several decades. Over this period, demand deposits lost their market share to money market mutual funds, which, while considered safe, are not guaranteed like deposits. This made it increasingly difficult and less profitable for banks to fund loans on their balance sheets using deposits. Securitization markets developed where loans could be funded through the market by investors. In addition, money market mutual funds, securities lenders, institutional investors and businesses needed a safe way to deposit funds where they would earn interest but retain ready access to their funds. Repurchase agreements or 'repos' developed to serve this need. A repo is a short-term collateralized loan that shares many characteristics with a demand deposit except that repos are not guaranteed. At the same time, large firms increasingly raised funds by issuing commercial paper in the market rather than relying on bank loans -- with the money market mutual funds being large investors in this paper. Large banks, as well, came to rely at the margin on non-deposit funding through the interbank funding market. The Fed acted as the lender of last resort for this market. This system of market-based credit intermediation has been called the 'shadow banking system.' The shadow banking system grew at a very fast rate over the past several decades.... A direct consequence of this growth was that the short-term liabilities associated with the shadow banking system -- repos and commercial paper -- exceeded the level of demand deposits.... Despite this rapid transformation of the financial system, the liquidity protections put in place for demand deposits (deposit insurance and access to the Fed's discount window) were not available to these new funding sources."
