Even though financial crises, recessions and depressions are nothing new in America, the severity of the 2007-2009 recession and ensuing financial crisis highlighted some weaknesses in our financial system and gaps in our regulatory system.
On Sept. 12, St. Louis Fed officials and a public audience explored the causes of and responses to the financial crisis during the first “Dialogue with the Fed” discussion, “Lessons Learned from the Financial Crisis.” Julie Stackhouse, senior vice president and managing officer for Banking Supervision, Discount Window Lending and Community Development, led the presentation and discussion. Joining her for an audience question-and-answer session were Mary Karr, the St. Louis Fed’s general counsel, and economists William Emmons and Silvio Contessi.
United States Government
Federal Deposit Insurance Corp.
According to a December 2009 congressional report, the chain of events leading to the severe crisis in the fall of 2008 began with an asset bubble in housing, expanded into the subprime crisis, escalated into a severe freeze-up of the interbank lending market, and culminated in intervention by the U.S. and other industrialized countries to rescue their respective banking systems.
Numerous assumptions, miscues and efforts to transfer risk to other parties combined to trigger the crisis. As Stackhouse explored in her presentation, several lessons have been culled from those underlying causes.
High levels of debt, uncertain ability of borrowers to repay debt and an expectation that housing prices will always increase (among other factors) created a comfort level that was misguided.
“Too much debt that does not have a clear ability to be repaid and is dependent on an asset—typically land—going up in price is a recipe for disaster,” said Stackhouse. “We like to think that values will always increase over time; we need to begin to think that they might not. And you have to be able to repay your debt—particularly when it’s a big debt on your balance sheet.
“This is one of those lessons that has to be learned and relearned and relearned. And the risk was a lot harder to see this time around because it was so spread out over the financial system,” she said.
Risk needs to be understood across all parts of the financial system, including banks and nonbanks. Spreading risk outside of the insured banking system and the use of “insurance” policies, such as credit default swaps, did not result in risk diversification.
Why, though, didn’t the Fed see it? “Our regulatory structure was not built to see this risk,” she said, because different agencies oversee different components of the financial industry. Not all risk is found in banks; many times, risk is in financial institutions that aren’t banks, such as insurance companies and investment houses (the so-called shadow banking system).
Stemming from this lesson, a new Financial Stability Oversight Council was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The council is charged with monitoring risk across all financial sectors. If the council identifies a new systemically important financial institution, it will be supervised by one regulator, the Federal Reserve.
Choices made in the short run may have long-run consequences that need to be carefully considered.
During the housing bubble, many looked upon owning a home as a means for building wealth for retirement, based on the assumption that prices would always go up. “But if building wealth for retirement was a goal, then there were probably better and more certain choices than investing in a home,” Stackhouse said. “Looking back, it’s a simple lesson but probably one that we looked over a bit too quickly.”
In the fall of 2008, the Federal Reserve, the federal government and the Federal Deposit Insurance Corp. (FDIC) started using many tools to combat and stop the financial crisis. (See Figure 1 below.) The Fed repeated and expanded on a measure last used immediately after the 9/11 attacks: It injected liquidity via credit programs and loans to banks and financial organizations to get the financial markets moving again.
As Figure 2 below shows, the Fed’s balance sheet was fairly steady until the crisis became acute in fall 2008. The Fed initiated many lending facilities and used other long-standing liquidity measures, including working with foreign banks.
Weekly, January 2007 - August 2011, in billions of dollars
“That is our role: providing financial stability by being there to stop the panic but stepping out when the panic is done,” Stackhouse explained. “What’s not well-understood is that although the balance sheet got very large and peaked at a high level in the late winter of 2009, the programs enacted in response to the crisis have largely gone down to zero. Today there is very little left on the Federal Reserve’s balance sheet from the financial crisis programs.”
As seen in Figure 2, what’s left on the balance sheet—the large amounts from early 2009 to the present—represents the Fed’s efforts to stimulate the economy by purchasing bonds, mortgage-backed securities and U.S. Treasuries.
During the question-and-answer session, Emmons added that central bank liquidity—both here and abroad—ideally should be used only for emergencies. “We don’t want the central banks to be the only providers of liquidity—they’re the lenders of last resort,” he said. “We want the interbank markets to be the primary—almost exclusive—sources of liquidity. That lack [of a strong interbank market] is the problem in Europe right now.”
Previous experiences demonstrate that actions of central banks can stop a crisis in its tracks. But because of debt woes in Greece, Italy, Spain and other nations, Dialogue audience members were eager to know whether events in Europe threatened a new crisis that could spread to America.
Speaking specifically of the situation in Greece, Contessi said it wasn’t clear whether a crisis could be contained. “The direct exposure of the U.S. to the Greek financial system is small, but there is a lot of indirect exposure. Obviously many European banks own Greek debt, and there are bilateral relationships between U.S. and European banks,” he said.
“If any of those countries default, then the value of the Treasury bonds that banks hold may be very different within a few days of default. So, there is a chance that things could turn ugly,” he said.
“Direct and indirect exposure is where contagion comes from; that’s where panic is very dangerous,” Stackhouse said. “But that’s also where central banks step in to calm the fears by making sure that payments can be made where solvency otherwise exists. And of course the hard thing to judge is when solvency exists.”
Unrealistic comfort levels, assumptions, miscues and the failure to appreciate industry-wide risks converged to trigger the financial crisis. The Dodd-Frank Act is designed to deal with those shortcomings and help prevent a similar crisis in the future, but its costs and impact on the financial industry are not yet known.
Meanwhile, the Fed, along with the federal government and FDIC, proved once again that major financial crises are stoppable. Most of the Fed’s liquidity measures for the crisis itself have since fallen off the Fed’s balance sheet. And even though financial events in Europe could spread to the U.S., central banks still have the ability to inject liquidity into the markets.
While there is no magic bullet to prevent all financial crises, there is vigilance: “Risk will be something different tomorrow than it is today. The challenge will be to identify what the next thing is so that it doesn’t get ahead of the system designed to watch over it,” Stackhouse said.
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Financial Crisis Timeline
Liquidity Crises in the Small and Large
Federal Reserve Balance Sheet Information