On Friday, Federal Reserve Chairman Ben Bernanke gave his last address as Fed chief, a speech entitled, "The Federal Reserve: Looking Back, Looking Forward." Discussing "financial stability and financial reform," Bernanke says, "For the U.S. and global economies, the most important event of the past eight years was, of course, the global financial crisis and the deep recession that it triggered. As I have observed on other occasions, the crisis bore a strong family resemblance to a classic financial panic, except that it took place in the complex environment of the 21st century global financial system. Likewise, the tools used to fight the panic, though adapted to the modern context, were analogous to those that would have been used a century ago, including liquidity provision by the central bank, liability guarantees, recapitalization, and the provision of assurances and information to the public."

He continues, "The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices.... [T]he bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because ... it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole."

Bernanke explains, "The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions. However, the institutional context had changed substantially since Bagehot wrote. The panics of the 19th and early 20th centuries typically involved runs on commercial banks and other depository institutions. Prior to the recent crisis, in contrast, credit extension had progressively migrated outside of traditional banking to so-called shadow banking entities, which relied heavily on short-term wholesale funding that proved vulnerable to runs. Accordingly, to help calm the panic, the Federal Reserve provided liquidity not only to commercial banks, but also to other types of financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. Because funding markets are global in scope and U.S. borrowers depend importantly on foreign lenders, the Federal Reserve also approved currency swap agreements with 14 foreign central banks."

He tells us, "Providing liquidity represented only the first step in stabilizing the financial system. Subsequent efforts focused on rebuilding the public's confidence, notably including public guarantees of bank debt by the Federal Deposit Insurance Corporation and of money market funds by the Treasury Department, as well as the injection of public capital into banking institutions.... The subsequent efforts to reform our regulatory framework have been focused on limiting the reemergence of the vulnerabilities that precipitated and exacerbated the crisis. Changes in bank capital regulation under Basel III have significantly increased requirements for loss-absorbing capital at global banking firms--including a surcharge for systemically important institutions and a ceiling on leverage.... The Basel III framework also includes liquidity requirements designed to mitigate excessive reliance by global banks on short-term wholesale funding and to otherwise constrain risks at those banks. Further steps are under way to toughen the oversight of large institutions and to strengthen the financial infrastructure."

Bernanke adds, "Oversight of the shadow banking system also has been strengthened. For example, the new Financial Stability Oversight Council has designated some nonbank firms as systemically important financial institutions, or SIFIs, subject to consolidated supervision by the Federal Reserve. In addition, measures are being undertaken to address the potential instability of short-term wholesale funding markets, including reforms to money market funds and the triparty repo market. Of course, in a highly integrated global financial system, no country can effectively implement the financial reforms I have described in isolation. The good news is that similar reforms are being pursued throughout the world, with the full support of the United States and with international bodies such as the Basel Committee and the Financial Stability Board providing coordination."

He also says, "Much progress has been made, but more remains to be done. In addition to completing the efforts I have already mentioned, including the full implementation of new rules and supervisory responsibilities, the agenda still includes further domestic and international cooperation to ensure the effectiveness of mechanisms to allow the orderly resolution of insolvent institutions and thereby increase market discipline on large institutions."

Finally, Bernanke comments on monetary policy, "Once the economy improves sufficiently so that unconventional tools are no longer needed, the Committee will face issues of policy implementation and, ultimately, the design of the policy framework. Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC's ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate. It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change; the Committee will be considering this question in the future, taking into account what it learned from its experience with an expanded balance sheet and new tools for managing interest rates."

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