Simon Johnson's Latest on Bernanke and Too Big to Fail by Dean Baker
3. Not surprisingly, Mr. Bernanke often is asked to reflect on the financial crisis. He offered something a little different than his normal response on Friday night.
“In many ways, in retrospect, the crisis was a normal crisis,” he said. “It’s just that the intuitional framework in which it occurred was much more complex.”
In other words, there was a panic, and a run, and a collapse – but rather than a run on bank deposits, the run was in the money markets. Improving the stability of those markets is something regulators have yet to accomplish.*
5:33 p.m. | Updated to reflect alternative solutions proposed by the New York Fed chief.
The federal government has generally responded to the financial crisis by expanding the power of regulators, most of all the Federal Reserve. But in an interesting speech this month, William C. Dudley, president of the Federal Reserve Bank of New York, argued that Congress has not gone far enough.
Mr. Dudley’s concern is about a little-noticed piece of the 2010 Dodd-Frank Act that actually reduced the central bank’s authority in one crucial area: its ability to provide emergency funding to strapped financial firms.
The Fed arrested the 2008 financial crisis by using this authority to create a series of unprecedented programs that offered emergency financing not just to American banks – its traditional flock – but also to foreign banks, and not just to banks but to other kinds of financial companies as well, and indeed to other kinds of companies entirely.
Congress responded to this performance by making it difficult to repeat. Dodd-Frank imposed new restrictions on the Fed’s ability to make emergency loans, or to keep money flowing, outside the banking industry.
One basic reason was that Congress had never really intended to give the Fed such broad power in the first place. Rather remarkably, the authority that the Fed used to save the financial system in 2008 was granted by Congress in 1991 with almost no debate or public notice, a story I first told in The Washington Post in 2009. It was quietly slipped into a broader bill by former Senator Christopher Dodd of Connecticut, at the behest of Wall Street companies including Goldman Sachs. When it was first used almost two decades later, legislators like Representative Barney Frank confessed that they didn’t know they had voted for it.
Furthermore, everyone agreed that the 1991 law didn’t make much sense. It expanded the Fed’s safety net without expanding its regulatory authority. Banks are backstopped and, at least in theory, carefully regulated. Backstopping the rest of the financial system without regulation was an invitation to excess. There’s a reasonable argument that that contributed to the crisis.
But rather than expanding regulation, Congress decided to pull in the net.
This decision commanded broad support. Bailing out financial firms is not a popular spectator sport, and there is a general consensus in Washington that public policy should focus on minimizing the damage when firms fail.
“Many – myself included – have drawn from the financial crisis the conclusion that government safety nets should be drawn tightly so that only a very few, very tightly regulated firms get as little liquidity support as possible,” Karen Shaw Petrou, a close watcher of financial regulation who drew my attention to Mr. Dudley’s speech, wrote to clients of her firm, Federal Financial Analytics.
A more inclusive policy, she continued, “will open the safety net, wide, wide open to all sorts of actors who, smiling sweetly, will rob us blind.”
Mr. Dudley takes the opposite view. He argued in his recent speech that it would make no sense to draw a line between banks and other kinds of financial firms if both were playing essentially the same role in the broader economy.
Both should be regulated, and both should be backstopped.
“If we believe that these activities provide essential credit intermediation services to the real economy that could not be easily replaced by other forms of intermediation, then the same logic that leads us to backstop commercial banking with a lender of last resort might lead us to backstop the banking activity taking place in the markets in a similar way,” he told the New York Bankers Association.
Perhaps the most powerful argument for this view is that the absence of a broader backstop is the mechanism by which a housing crash became a financial crisis.
The government stabilized deposit funding through the creation of the Federal Reserve, as an emergency lender to strapped banks, and the Federal Deposit Insurance Corporation, as a guarantor that depositors would get their money back.
But banks and other financial companies increasingly draw money from sources that do not have similar backstops, including the sale of commercial paper to money market funds and complicated arrangements called “triparty repos” that basically allow financial firms to borrow money by pledging assets as collateral.
These are short-term loans that must be renewed regularly, often daily. As a result, panic among investors can almost instantly undermine financial stability, which is exactly what began to happen in 2007: Panic spread, financing disappeared, and the global financial system came perilously close to complete collapse.
There is broad agreement that something should be done to improve the stability of money-market funds and the triparty repo market. So far, nothing much has happened, but one can’t rule out the possibility that that will change.
Mr. Dudley favors many of these efforts, but his broader point is that they all are insufficient. There is no substitute for the role the Fed now plays in the banking system, as a lender of last resort – and not just the emergency authority granted to the Fed in 1991, but authority to serve as a permanent backstop.
Alternatively, he noted that regulators could instead choose to restrict the use of unstable funding sources, but that is a solution many regard as impractical.
Perry Mehrling, an economist at Barnard College, argued in a 2011 book, “The New Lombard Street,” that it had never made sense to restrict the Fed’s backstop to the traditional banking system, because banks had always been part of a broader system, all of which required the same regulation and support.
“The practical intertwining of money markets and capital markets is the defining institutional feature of the American system, and that feature requires a similarly integrated backstop by the central bank,” Professor Mehrling wrote.
The only choice, he argued, was between planning carefully for the next crisis, or repeating the Fed’s ad-hoc any-tools-available response in 2008.
Mr. Dudley appears to be in complete agreement with that view.
“The sheer size of banking functions undertaken outside commercial banking entities – even now, after the crisis – suggests that this issue must not be ignored,” he said. “Pretending the problem doesn’t exist, or dealing with it only ex post through emergency facilities, cannot be consistent with our financial stability objectives.”