Federal Reserve Bank of New York President William Dudley, who recently announced his retirement in 2018 spoke recently on "Lessons from the Financial Crisis." He says, "As we mark the tenth anniversary of the onset of the financial crisis, I would like to focus on some of the lessons we should draw from that harrowing experience, and the implications of those lessons for regulatory policy going forward.... The evolution of the financial crisis illustrates a number of key issues, including the potential hazards of financial innovation, the procyclicality of the financial system, and the importance of confidence in sustaining effective financial intermediation."
Dudley continues, "Once the housing bust got underway, stress on the financial system increased sharply as asset prices fell and bank earnings plunged. In the spring of 2008, such pressures led to a forced sale of Bear Stearns to JPMorgan Chase. Later in the year, the government placed Fannie Mae and Freddie Mac into conservatorship. In September, Lehman Brothers failed. And, a day later, AIG was rescued in order to protect the rest of the financial system against further losses and even broader contagion. With confidence in financial markets and financial intermediaries badly frayed, the Federal Reserve and the U.S. government intervened and provided a range of liquidity backstops, debt guarantees, and capital infusions to forestall a complete collapse of the financial system and the economy."
He explains, "The bust exposed many structural flaws in the financial system that exacerbated its instability. Without being exhaustive, these included the instability of the tri-party repo system, which supported the nation's short-term funding markets; the risks of runs in the money market mutual fund industry; and the risk of contagion caused by the huge volume of outstanding bilateral (non-centrally cleared) over-the-counter (OTC) derivative obligations between the major financial intermediaries."
Dudley tells us, "The tri-party repo system was centered on two of the major U.S. banks. The system matched investors and borrowers each day -- with the investors lending cash, secured by Treasuries and other collateral, to the major securities firms. But, the system was unstable. In times of stress, clearing banks could be faced with very large single-firm exposures -- of potentially hundreds of billions of dollars. Not surprisingly, when such counterparties became troubled, the clearing banks were less willing to take on these large intraday exposures. As a result, repo investors, who were primarily worried about getting repaid each morning, were motivated to simply withdraw from the market. As short-term investors withdrew funding, the liquidity buffer of the troubled securities firm was quickly exhausted, particularly as other counterparties to that firm demanded additional collateral to secure their own exposures."
He notes, "Structural weaknesses in the money market mutual fund industry -- which was a major source of short-term wholesale funding to the securities industry and various non-bank financial corporations -- also exacerbated the crisis. When Lehman Brothers failed, the value of its outstanding short-term obligations collapsed. The Reserve Primary Fund 'broke the buck,' and investors rushed to withdraw their funds from prime institutional money market mutual funds in a modern version of a classic 'bank run.' The funds generally did not have sufficient cash available to meet these runs because they offered overnight liquidity at par value against a portfolio of assets with weighted average maturities that were considerably longer."
Dudley states that we can take three critical lessons away from the financial crisis. He says, "First, financial institutions must be robust to stress. In particular, they need to have enough capital to be considered solvent even after sustaining significant losses, so that they can maintain the market access needed to recapitalize.... Second, when we identify potential sources of instability that could amplify shocks, we need to make structural changes to the financial system to reduce or eliminate them. For example, the financial crisis made it clear that changes were needed in how tri-party repo transactions were unwound each day, net asset values were calculated for prime money market mutual funds, and OTC derivative obligations were cleared, settled, and risk-managed. Third, there should be a viable and predictable resolution regime."
He also comments, "We have also made significant progress in addressing many of the structural weaknesses uncovered by the financial crisis. Money market reform has made the prime money market mutual fund industry smaller and safer. The elimination of the net asset value convention for institutional prime money market mutual funds has made these funds smaller and less prone to runs during times of crisis. The tri-party repo system has been made more stable as intraday exposures of the large clearing banks have been dramatically reduced. This means that they have less reason to back away from a firm if it were to become troubled. And, firms are much less reliant on short-term wholesale funding."
Dudley continues, "The Federal Reserve's lack of authority to lend to a major securities dealer that gets into difficulty is another outstanding issue. The Dodd-Frank Act narrowed the Federal Reserve's authority under Section 13(3) of the Federal Reserve Act. No longer can the Federal Reserve lend to an individual securities firm or non-bank financial intermediary. Such authority may not be as necessary now that the Federal Deposit Insurance Corporation (FDIC) has the power to lend under Title II of the Dodd-Frank Act and firms are required to have sufficient resources to support their resolution plans. But, I would prefer having such a tool available in extremis given the potential need to buy time for coordination and critical decision-making. I think it is important to ensure that one can 'get to the weekend'."
Finally, he adds, "In conclusion, as we reflect on potential changes to the U.S. regulatory regime, we should not lose sight of the horrific damage caused by the financial crisis, including the worst recession of our lifetimes and millions of people losing their jobs and homes. We had a woefully inadequate regulatory regime in place, and while it is much better now, there is still work to do. We should finish the job as quickly as possible, and we should do no harm as we adjust our regulatory regime to make it more efficient."
The release on Dudley's pending retirement tells us, "The Federal Reserve Bank of New York today announced that William C. Dudley, president and chief executive officer, intends to retire from his position in mid-2018 to ensure that a successor is in place well before the end of his term. Mr. Dudley's term ends in January of 2019 when he reaches the 10 year policy-limit in the role. Mr. Dudley joined the New York Fed in 2007 as executive vice president and head of the Markets Group, where he also managed the System Open Market Account for the Federal Open Market Committee (FOMC). He was named the 10th president and CEO of the New York Fed on January 27, 2009, taking over the remainder of his predecessor's term."
