By Denny Gulino and Sheila Mullan

NEW YORK (MNI) – Federal Reserve Chairman Ben Bernanke Friday said
the financial crisis and the Fed responses to it were not as novel as
they might appear, and instead were fundamentally a “classic” panic and
central bank reaction described in the history books.

Bernanke, speaking to the Russell Sage Foundation and The Century
Foundation, stuck to his interpretation of the complicated history of
the 2007-2009 crisis and how it was handled, and did not address the
current state of the economy or monetary policy alternatives.

Yet his message was forward looking, that regulators must keep
examining the vulnerabilities of the financial system, a process well
along but far from completed. And he repeated that in the post-crisis
era, the Fed and all central banks now face a responsibility to
stabilize the financial system that is equal to their mission to manage
monetary policy.

Distinguishing between crisis triggers and structural
vulnerabilities, Bernanke said the subprime mortgage mess was big, but
hardly large enough to account for all the crisis damage. In fact, a
single days routine losses in world markets can be even larger.

House price declines, however, accounted for much larger losses and
were also a trigger.

“In contrast, the vulnerabilities were the structural, and more
fundamental, weaknesses in the financial system and in regulation and
supervision that served to propagate and amplify the initial shocks,” he
said.

Subprime mortgage losses were around a trillion dollars, and house
price losses were seven times that. “However, on closer examination, it
is not clear that even the large movements in house prices, in the
absence of the underlying weaknesses in our financial system, can
account for the magnitude of the crisis,” he said.

More paper wealth, more than $8 trillion, was destroyed by the
earlier so-called dot-com collapse.

“The explanation of the differences between the two episodes must
be that the problems in housing and mortgage markets interacted with
deeper vulnerabilities in the financial system in ways that the dot-com
bust did not,” he said. While recounting the many interacting causes and
vulnerabilities of the crisis, from shadow banking’s absence of
regulation to the shortcomings of the regulators themselves, Bernanke’s
larger message was that it was all fundamentally not that unusual
historically.

“To a significant extent,” he said, “the crisis is best understood
as a classic financial panic — differing in details but fundamentally
similar to the panics described by Bagehot and many others” in the 19th
century when economist Walter Bagehot was writing books still in print
today.

Bernanke said that deposit insurance has largely eliminated crowds
outside banks demanding their money. “But a panic is possible in any
situation in which longer-term, illiquid assets are financed by
short-term, liquid liabilities and in which providers of short-term
funding either lose confidence in the borrower or become worried that
other short-term lenders may lose confidence,” he said.

“Indeed, panic-like phenomena arose in multiple contexts and in
multiple ways during the crisis,” including in the repo market, he said.
“The secured nature of repo agreements gave firms and regulators
confidence that runs were unlikely. But this confidence was misplaced,”
he said.

“Once the crisis began, repo lenders became increasingly concerned
about the possibility that they would be forced to receive collateral
instead of cash, collateral that would then have to be disposed of in
falling and illiquid markets,” he continued. “Lenders responded by
imposing increasingly higher haircuts, cutting the effective amount of
funding available to borrowers. In other contexts, lenders simply pulled
away, as in a deposit run; in these cases, some borrowers lost access to
repo entirely, and some securities became unfundable in the repo
market.”

Bernanke detailed other kinds of panic-type phenomena. “Following
the Lehman collapse and the “breaking of the buck” by a money market
mutual fund that held commercial paper issued by Lehman, both money
market mutual funds and the commercial paper market were also subject to
runs,” he said.

“Overall, the emergence of run-like phenomena in a variety of
contexts helps explain the remarkably sharp and sudden intensification
of the financial crisis, its rapid global spread, and the fact that
standard market indicators largely failed to forecast the abrupt
deterioration in financial conditions,” Bernanke said.

Following the advice of the 19th century, “From the beginning of
the crisis, the Fed, like other major central banks, provided large
amounts of short-term as banks, on a broad range of collateral.”

The Fed “also provided backstop liquidity support for important
components of the shadow banking system, including money market mutual
funds, the commercial paper market, and the asset-backed securities
markets.”

The Fed, he said, was responding with “the best of bad options,
given the absence of a legal framework” in many cases.

“The financial crisis of 2007-09 was difficult to anticipate for
two reasons,” he said. “First, financial panics, being to a significant
extent self-fulfilling crises of confidence, are inherently difficult to
foresee. Second, although the crisis bore some resemblance at a
conceptual level to the panics known to Bagehot, it occurred in a rather
different institutional context and was propagated and amplified by a
number of vulnerabilities that had developed outside the traditional
banking sector.”

Bernanke said, though, that at its heart, the crisis was not that
unfamiliar. It turned out, “The panic could be addressed to a
significant extent using classic tools, including backstop liquidity
provision by central banks, both here and abroad.”

“To avoid or at least mitigate future panics, the vulnerabilities
that underlay the recent crisis must be fully addressed,” he concluded.
“As you know, this process is well under way at both the national and
international levels.” But nevertheless, “the events of the past few
years have forcibly reminded us of the damage that severe financial
crises can cause. Going forward, for the Federal Reserve as well as
other central banks, the promotion of financial stability must be on an
equal footing with the management of monetary policy as the most
critical policy priorities.”

** MNI New York Newsroom: 212-669-6430 **

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