NEW YORK (MNI) – The following is the fourth of seven sections
of Federal Reserve Chairman Ben Bernanke’s remarks titled “Rethinking
Finance: Perspectives on the Crisis” prepared for the Russell Sage
Foundation and The Century Foundation:

Classic panic-type phenomena occurred in other contexts as well.
Early in the crisis, structured investment vehicles and many other
asset-backed programs were unable to roll over their commercial paper as
investors pulled back, and the programs were forced to draw on liquidity
lines from banks or to sell assets.6 The resulting pressure on the bank
liquidity providers, evident especially in the market for
dollar-denominated loans in short-term funding markets, impeded the
functioning of the financial system throughout the crisis. 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.7
More generally, during the crisis, runs of short-term uninsured
creditors created severe funding problems for a number of financial
firms, including several large broker-dealers and also some bank holding
companies.

In some cases, withdrawals of funds by creditors were augmented by
“runs” in other guises — for example, by prime brokerage customers of
investment banks concerned about the safety of cash and securities held
at those firms or by derivatives counterparties demanding additional
margin.8 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.

The multiple instances of run-like behavior during the crisis,
together with the associated sharp increases in liquidity premiums and
dysfunction in many markets, motivated much of the Federal Reserve’s
policy response.9 Bagehot advised central banks — the only institutions
that have the power to increase the aggregate liquidity in the system —
to respond to panics by lending freely against sound collateral.
Following that advice, from the beginning of the crisis, the Fed, like
other major central banks, provided large amounts of short-term
liquidity to financial institutions, including primary dealers as well
as banks, on a broad range of collateral.10

Reflecting the contemporary institutional environment, it 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. To be
sure, the provision of liquidity alone can by no means solve the
problems of credit risk and credit losses, but it can reduce liquidity
premiums, help restore the confidence of investors, and thus promote
stability. It can also reduce panic-driven credit problems in cases in
which such problems result from price declines during liquidity-driven
fire sales of assets.

The pricing of the liquidity facilities was an important part of
the Federal Reserve’s strategy. Rates could not be too high; to have a
positive effect, and to minimize the stigma of borrowing, the facilities
had to be attractive relative to rates available (or nominally
available) in illiquid, dysfunctional markets. At the same time, pricing
had to be sufficiently unattractive that borrowers would voluntarily
withdraw from these facilities as market conditions normalized. This
desired outcome in fact occurred: By early 2010, emergency lending had
been drastically reduced, along with the demand for such lending.

The Federal Reserve’s responses to the failure or near failure of a
number of systemically critical firms reflected the best of bad options,
given the absence of a legal framework for winding down such firms in an
orderly way in the midst of a crisis–a framework that we now have.
However, those actions were, again, consistent with the Bagehot approach
of lending against collateral to illiquid but solvent firms. The
acquisition of Bear Stearns by JPMorgan Chase was facilitated by a
Federal Reserve loan against a designated set of assets, and the
provision of liquidity to AIG was collateralized by the assets of the
largest insurance company in the United States. In both cases the
Federal Reserve determined that the loans were adequately secured, and
in both cases the Federal Reserve has either been repaid with interest
or holds assets whose assessed values comfortably cover remaining loans.

To say that the crisis was purely a liquidity-based panic would be
to overstate the case. Certainly, an important part of the resolution of
the crisis involved assuring markets and counterparties of the solvency
of key financial institutions, and that assurance was provided in
significant part by the injection of capital, including public capital,
and the issuance of guarantees–measures not available to the Federal
Reserve. In these respects, the Treasury-managed Troubled Asset Relief
Program and the FDIC’s Temporary Liquidity Guarantee Program played
critical roles. As I have noted, the Federal Reserve did help restore
confidence in the solvency of the banking system by leading the stress
tests of the 19 largest U.S. bank holding companies in the spring of
2009. These stress tests, which were both rigorous and transparent,
helped make it possible for the tested banks to raise $120 billion in
private capital in the ensuing months.

The response to the panic also involved an extraordinary amount of
international consultation and coordination. Following a key meeting of
the Group of Seven finance ministers and central bank governors in
Washington on October 10, 2008, the governments of other industrial
countries took strong measures to stabilize key financial institutions
and markets. Central banks collaborated closely throughout the crisis;
in particular, the Federal Reserve undertook swap agreements with 14
other central banks to help ensure adequate dollar liquidity in global
markets and thus keep credit flowing to U.S. households and businesses.

-more- (4 of 7)

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