Federal Reserve Chairman Ben Bernanke spoke yesterday on "Causes of the Recent Financial and Economic Crisis" before the Financial Crisis Inquiry Commission. Bernanke discussed short-term funding problems, shadow banking and commented briefly on money market mutual funds' role in the crisis. He said, "Chairman Angelides, Vice Chairman Thomas, and other members of the Commission, your charge to examine the causes of the recent financial and economic crisis is indeed important. Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition."
Bernanke explained, "In midsummer 2007, events unfolded that would engender a sea change in money market conditions, triggered by fears of subprime losses that had been growing during the first half of the year. To choose one of several possible key dates, on July 30, 2007, IKB, a medium-sized German bank, announced that in order to meet its obligations, it would be receiving extraordinary support from its government-owned parent and an association of German banks. IKB's problem was that its Rhineland off-balance-sheet vehicle was no longer able to roll over the asset-backed commercial paper (ABCP) it had been issuing in U.S. markets to fund its large portfolio of asset-backed securities. Although none of the securities in the Rhineland portfolio was in default and only some were subprime-related, commercial paper investors had become concerned about IKB's ability to meet its obligations in the event that the securities Rhineland held were downgraded."
He continued, "Around the same time, other vehicles similar to that of Rhineland were also finding funding rollovers to be more costly and difficult to arrange. These difficulties intensified over subsequent weeks, as investors around the world pulled back funding; indeed, outstanding U.S. ABCP plummeted almost $200 billion in August. The economist Gary Gorton has likened this pullback to a traditional bank run: Lenders in the commercial paper market and other short-term money markets, like depositors in a bank, place the highest value on safety and liquidity. Should the safety of their investments come into question, it is easier and safer to withdraw funds -- 'run on the bank' -- than to invest time and resources to evaluate in detail whether their investment is, in fact, safe.... Ultimately, the disruptions to a range of financial markets and institutions proved far more damaging than the subprime losses themselves."
Talking on "Dependence on Unstable Short-Term Funding," be commented, "Shadow banks are financial entities other than regulated depository institutions (commercial banks, thrifts, and credit unions) that serve as intermediaries to channel savings into investment. Securitization vehicles, ABCP vehicles, money market funds, investment banks, mortgage companies, and a variety of other entities are part of the shadow banking system. Before the crisis, the shadow banking system had come to play a major role in global finance; with hindsight, we can see that shadow banking was also the source of some key vulnerabilities."
Bernanke said, "As was illustrated by the ABCP market meltdown discussed earlier, the reliance of shadow banks on short-term uninsured funds made them subject to runs, much as commercial banks and thrift institutions had been exposed to runs prior to the creation of deposit insurance. A run on an individual entity may start with rumors about its solvency, but even when investors know the rumors are unfounded, it may be in their individual interests to join the run, as few entities can remain solvent if their assets must be sold at fire-sale prices. Thus, fears of a run have the potential to become at least partially self-fulfilling, and a run may blur the distinction between an insolvent and an illiquid firm."
He commented, "Money market mutual funds proved particularly vulnerable to liquidity pressures. A large portion of the investments of these funds were in short-term wholesale funding instruments issued or guaranteed by commercial banks. When short-term wholesale funding markets came under stress, particularly in the period after the collapse of Lehman Brothers, money market mutual funds faced runs by their investors. Although actions by the Treasury and the Federal Reserve helped arrest these runs, the money market mutual funds responded by hoarding liquidity, thus constricting the availability of financing to financial and nonfinancial firms."
Finally, Bernanke told the FCIC, "In a time of panic and liquidity shortages, central banks must be able to provide funding to sound financial institutions. In the United States, the Federal Reserve lacked established procedures to provide short-term funding to shadow banks, such as broker-dealers, money market mutual funds, or special purpose vehicles, so it had to develop programs to provide such funding quickly during the crisis.... However, the Federal Reserve was able to supply liquidity to both banks and nonbanks, through a variety of means, to stem the panic. It auctioned fixed amounts of term funding to depository institutions, which seemed to circumvent the stigma problem. The Federal Reserve also created other facilities, in most cases using its emergency authority under section 13(3) of the Federal Reserve Act, to provide collateralized short-term loans to nonbank financial institutions in situations in which market-based funding mechanisms had broken down."
