Good afternoon. I want to thank the conference organizers for inviting me to this very timely and relevant conference. I will be expressing my own views, and not those of the Federal Reserve System or the Federal Reserve Bank of New York.
The times are extraordinary, and the conference agenda reflects it. The years of financial turbulence that we have experienced and continue to experience have illuminated both the power and the limitations of government intervention in managing financial crises. These years have illustrated how much more we need to understand about good design principles for intervention and sound strategies for the restoration of financial and banking market function following a crisis. And these years have highlighted the interaction between the fiscal condition and capacity of countries and the size and health of the domestic financial system. The conference agenda touches on all of these.
I speak of government intervention broadly, because the answer to the provocative question I am to discuss—how can we conduct crisis management without financial guarantees—depends a great deal on which types of government intervention we hope to avert. Certain guarantee or contingent arrangements can short-circuit incipient instability or stabilize already roiled financial institutions and markets; we do not want to end them. Other interventions are more intrusive and involve more socialization of loss; we want to reduce their necessity.
Guarantee has a legal meaning—for example, the Federal Reserve is not authorized to issue a guarantee—but I will use the word more broadly to describe contingent arrangements. Definitions of guarantee are variations of: "a warrant, pledge, or formal assurance given as security that another's debt or obligation will be fulfilled"; in the financial sector, that primarily means credit risk protection.
Guarantees, insurance and options have similar structures. They are contingent, they have prices and triggers, and the payout is meant to cover a specific risk. Because guarantees, like insurance, change the risks to the guaranteed party and its creditors, both third-party guarantees and insurance can change the affected parties' behavior in an adverse way, and therefore create moral hazard. Thus, the provision of a guarantee also involves various control activities—underwriting, monitoring, imposing penalties for deviation from terms—intended to correct those incentives. The cost of the guarantee therefore is not only the cost of hedging and absorbing credit risk, but also the costs of control activities and an adjustment for any social efficiency gains or losses.
One reason that I draw the connection
between guarantees, insurance and options is that the theory and technique
for valuing insurance and options have advanced substantially in the last three
decades. Thus, guarantees can in concept be valued. I stress "in concept" because
those valuation efforts are still approximate. But the measures show promise.
For example, Deborah Lucas and Robert L. McDonald in a 2006 Journal of
Monetary Economics paper used a "stress value at risk" measure
to capture the risk in the implicit government guarantee to Fannie Mae and
Freddie Mac and obtained values that indicated the large and growing risk of
those institutions. The value of a guarantee, even an approximation of its
value, provides a potentially powerful signal of risk to the financial authorities.
Let me now turn to the U.S. experience during the recent financial crisis to describe an approach to characterizing the spectrum of government interventions.
The U.S. Experience with Intervention During the 2008-09 Financial Crisis
Of course, no one can do justice in a few minutes to the unprecedented central bank and government interventions during the 2008-09 financial crisis. Fortunately, much information is available on the internet; for example, www.federalreserve.gov contains a section called "Credit and Liquidity Programs" with a wealth of detail on the Fed's actions during the crisis.
The United States employed four major types of interventions in the financial crisis. The first interventions were expanded programs providing liability insurance. The Federal Deposit Insurance Corporation (FDIC) raised the standard deposit insurance coverage limit. The FDIC established a Temporary Liquidity Guarantee Program with two arms—a transaction (checking) account program that effectively covered corporate deposits and a debt guarantee program that covered unsecured short- and medium-term financial company debt. In addition, the U.S. Treasury offered insurance for money market mutual funds to curb "run risk" in those funds.
The second interventions were the market liquidity facilities provided by the Federal Reserve. While the Fed has authority to lend on a collateralized basis to banks, a large proportion of U.S. short- and medium-term funding for financial and nonfinancial firms now occurs in markets. The triparty repo market finances securities holdings for broker-dealers; the commercial paper market provides working capital for corporations; the asset-backed commercial paper and securities markets fund receivables and loans arising in business activities.
Under section 13(3) of the Federal Reserve Act, in unusual and exigent circumstances, the Federal Reserve can make loans to nonbank borrowers. As funding markets came under duress in 2008 and 2009, the Federal Reserve acted in a series of these markets. The common problem in each market was concern that an obligation would not be repaid at maturity because the obligor might experience either credit problems or liquidity constraints.
The interesting "contingent" aspect of these liquidity facilities was the pricing. The price, expressed as a borrowing rate, was set to stand well above the interest rates that prevailed prior to the crisis, but well below the rates then posted in strained markets. The pricing created a dynamic in which the availability of the facility eased funding pressures, borrowing rates in that market began to fall, and as markets gradually normalized, the market rate eventually fell below the rate charged by the Federal Reserve. With that fall in the market rate, borrowing tailed off and the facility gradually wound down. The volume of transactions in the facility and the market pricing gave the Federal Reserve—and market participants—insight into the program's impact and the market's recovery.
The third interventions were more firm specific: loans and other support to AIG, assistance to the Bear Stearns merger and an asset guarantee program announced for two financial institutions and implemented for one. The fourth and most well-known interventions were the capital injections in financial firms using funds from TARP, the U.S. government's Troubled Asset Relief Program.
These various interventions can be arrayed along two dimensions. The first is the nature and extent of loss absorption inherent in the design of the intervention—just how much "tail" or catastrophe risk the government is taking on. For deposit insurance arrangements, long experience suggests that the cost of the "tail" of losses during even a very distressed period is low relative to the benefits of prevention of runs and contagion. Similarly, the Fed's market liquidity facilities were meant to provide a backstop for market funding, predicated on the soundness of the underlying collateral assets and their margining. Moreover, both types of programs required little upfront investment of cash. In contrast, the direct loan to AIG, while collateralized, and the TARP investments involved substantial risk-taking and massive funding.
The second dimension is the economic cost of the intervention—just how intrusive the intervention is. All forms of intervention require some kind of underwriting, monitoring and enforcement, and many distort private market incentives and function, as I noted earlier. Ideally, I would include measures of both administrative costs and economic distortion in total cost.
Each intervention involved administrative burdens of varying extent. The FDIC's and Treasury's liability insurance programs rested largely on the existing licensing and supervision of regulated financial companies. The Federal Reserve's liquidity facilities rested on eligibility standards for borrowers and collateral, with a heavy reliance on the existing market infrastructure and processes for controls. By contrast, the firm-specific interventions required significant firm and examiner resources and extensive new financial controls. The TARP capital injections involved not only statutory constraints, most notably on executive compensation, but also a high level of scrutiny through public reports by the Congressional Oversight Panel and the Special Inspector General for TARP.
There are actual and potential programs that fall between the poles on both dimensions. The Term Asset-Backed Securities Loan Facility (TALF) created by the Federal Reserve to restart asset securitization markets lent to investors against asset-backed securities for terms of three and five years. Arguably, the Fed took on more risk of loss with the term of the loan, its non-recourse nature, and the type of collateral than it did in its other facilities. For that reason, TALF was complemented by arrangements for any work-out of defaulted collateral and was supported by TARP funding. On the administrative side, both borrowers and collateral had to meet eligibility requirements; the Federal Reserve Bank of New York extensively reviewed potential collateral and conducted compliance reviews at dealers arranging TALF borrowing.
The types of interventions for any given country will reflect its financial system structure and its institutional setting. The U.S. approach reflected the heavy reliance on markets and nonbanks for financing specific to our financial system. In addition, judgments about how much government loss absorption and intrusion are appropriate in central bank and government interventions will reflect country-specific circumstances and preferences.
As a final note, what didn't work well in the U.S. experience were implicit guarantees—that is, assumptions that the government would protect holders of certain liability and equity instruments that had no explicit guarantee. Official actions that laid bare the absence of the explicit guarantee—the imposition of losses on equity and subordinated debt investors when Fannie Mae and Freddie Mac were taken into conservatorship and on senior unsecured bondholders in the resolution of Washington Mutual—contributed to the dynamic of escalating panic in Fall 2008. Each action was one more shock at the time, but the investors' shock also pointed to the lack of hoped-for monitoring and market discipline by debt and equity investors in the run up to the crisis.
Contingent Arrangements and Financial Institution Failure
Guarantees as I described them earlier are about protection against failure to meet financial obligations, that is, against default and insolvency. The alternative to escalating government intervention during the crisis was accepting a higher rate of financial institution insolvencies. The consequences of multiple failures of large, complex and international organizations were largely unknowable. They included the likelihood of disruption of systemically important financial activities (such as payment services, where the customer need is immediate and customers cannot quickly switch to another provider) and the almost certain contagion to other institutions. The September 2008 bankruptcy of Lehman Brothers Holdings, Inc., underscored the difficulty of controlling the ramifications of the failure of just one large cross-border institution and the cost, complexity and extreme inefficiency of the existing cross-border insolvency process.
The "too big to fail" problem—the expectation that a large financial institution insolvency would be too disorderly and too destructive of wealth for financial authorities to risk—has frustrated financial authorities, legislators, and academics since at least the failure of Continental Illinois Bank in 1984. In the wake of the crisis, the frustration is now shared by the public. Having intervened so forcefully in the crisis, financial authorities and others also worry that moral hazard has increased as a result.
An important avenue to tackle the too-big-to-fail problem is to improve the feasibility of cross-border resolution of large financial firms. The Financial Stability Board (FSB) in 2009 commissioned work on improving the process for cross-border resolution of systemically important financial institutions. The work since then is reflected in a set of proposed principles published for consultation by the FSB in July 2011, Key Attributes of Effective Resolution Regimes.
The Key Attributes paper is more than a set of principles or emerging standards; the paper also maps out a series of actions to be taken in order to improve the feasibility of resolving a systemically important financial firm. The goal is to take actions that ease and speed the resolution of the largest firms while preserving critical functions and reducing the contagion and destruction of value that occurs in liquidation and, most important, to do so without recourse to public funds that exposes taxpayers to risk of loss.
The FSB proposes that all jurisdictions have a set of resolution powers, among them, the ability to create a bridge or similar institution, into which the healthy parts of a financial firm, including its critical activities, can be placed. In addition, the resolution authority needs the power to transfer, sell and restructure all or part of the firm. These powers have been used successfully by the FDIC in the United States, and a number of jurisdictions have adopted or have plans to adopt similar powers. The increased international use of bridge institutions is likely to require jurisdictions to recognize bridge banks from other countries, in order that some business functions, such as payment activities, can seamlessly transition to the successor bridge institution.
The bridge institution concept is quite powerful. The FDIC recently published a paper in its Quarterly that described how it could have handled the Lehman bankruptcy using its new powers under the Dodd-Frank Act to resolve systemically important nonbank financial institutions. The FDIC outlines how it could have created a bridge institution for the Lehman holding company, how it could have transferred to the bridge Lehman's equity holdings in its key subsidiaries, including its major broker/dealers, potentially avoiding their insolvency, and how it could have funded the London broker/dealer, a key problem following Lehman Holdings' bankruptcy in New York. Selling the broker/dealer subsidiaries as going concerns would preserve far more of their value and continuity of operations, as illustrated by the sale of most of Lehman's U.S. broker/dealer, which did not immediately enter insolvency.
The FDIC's article offers a promising path toward a workable cross-border insolvency process, a potential solution to a daunting problem, especially when viewed against the meaningful, but small progress made in the efforts of the past two decades. To build out the FDIC's proposed path to a workable cross-border insolvency process requires conforming changes to laws and rules across most jurisdictions. I do not want to minimize the challenges in developing the approach further, but simply highlight its potential to ameliorate a problem we would all like solved.
The FSB also proposes to make the process of recovery planning by firms and resolution planning by financial authorities an important principle. This planning, already underway for many systemically important financial firms, is being carried out by firm-specific crisis management groups, made up of regulators and resolution authorities from the jurisdictions where a given firm has its principal operations. The FSB also sets a broad direction for involving and communicating with host country jurisdictions where the host authorities view the financial firm to be of local systemic importance.
The FSB further proposes that the home country authorities, collaborating and coordinating with the crisis management group, produce an annual resolvability assessment. This assessment would identify a set of impediments to resolution and provide a list of follow-up actions, potentially some for the firm, but also some for the jurisdiction. Progress on the follow-up actions would be assessed in the following year.
The stated goal of the FSB's work is to make possible the resolution of systemically important financial institutions without exposing taxpayers to risk of loss. That will not happen overnight. In my view, we should be striving year by year to improve the feasibility and possibility of cross-border resolution. That means a dynamic assessment process that seeks improvement against the current baseline and addresses key changes in the firm and in the industry that either facilitate or complicate resolution. A stronger, more common resolution framework, a meaningful resolution planning process, and an annual resolvability assessment to ensure progress should make resolution a stronger alternative to government intervention.
Final Thoughts on Crisis Management Without Government Guarantees
Financial authorities are never really out of the crisis management business. The recent U.S. experience with crisis has illuminated vulnerabilities in the U.S. financial system, such as the role and structure of the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, and the need for reform in the triparty repo market and the money market mutual fund sector.
The systematic search for such points of vulnerability and new ones should be an important and permanent part of the work at the domestic and the international levels by financial authorities. What we need in the financial system is defense in depth, a series of actions both macro- and micro-prudential, that help prevent crises and help us manage them more effectively when they occur. The preventive measures include the new proposed Basel rules on capital and liquidity, intended to make financial institutions more resilient, especially systemically important firms; the international effort to strengthen the market infrastructure and supervisory oversight of financial derivatives; in the United States, the extension of comprehensive supervision to systemically important nonbank financial firms; and our ongoing efforts to reform the GSEs, the triparty repo market and the structure of money market mutual funds.
So let me conclude with some thoughts on the question of how close we might get to crisis management without government guarantees. For me, the paradigm of managing crises was the U.S. response in the early 1990s to its real-estate and leveraged buyout problems; while smaller than the more recent problems, the potential losses then threatened to engulf some of our largest banks. The paradigm consisted of three interconnected elements: identifying and isolating the problem assets for dedicated work-out management; replenishing the capital and liquidity of the firm; and drawing up new and credible business plans demonstrating the future profitability of the firm. The supervisors sought to be pre-emptive and proactive—propelling firms to acknowledge problems and take actions earlier than they might otherwise would have.
Where this paradigm was applied, we avoided failure. That experience illustrates that there is no substitute for early intervention in preserving value in the firm and in limiting externalities and other spillovers. Early intervention calls for strong supervisory oversight, as envisioned by the Basel Committee on Banking Supervision. It is significant that the FSB's Key Attributes paper on resolution highlights the important role of recovery planning by firms. Recovery planning and the dialogue with and among supervisors that accompanies it should facilitate early intervention. The recovery plan will already be on paper and the supervisory dialogue begun even before the firm starts to experience difficulty.
Early intervention will also be essential in resolution if recovery efforts fail. The Key Attributes highlights the need for resolution authorities to be able to act before technical insolvency. Resolution planning should once again facilitate that difficult decision to place a firm into an insolvency proceeding when it is necessary.
Second, government intervention measures such as those I described at the outset cannot substitute for the hard work that goes on in a private restructuring or in resolution. For example, even after the passage of a massive TARP fund and the injection of capital into the largest banks, market pressures continued for some banks, and those pressures only eased with more intervention, the thorough Supervisory Capital Assessment Program, also called the stress tests, for which results were disclosed, and a plan for specific capital actions by some firms. Problems need to be identified, capital and liquidity raised, new business plans put in place and old ones abandoned. Delays in taking and executing these hard, for the firm often life-changing, decisions contribute to the necessity for further intervention.
Third, I believe having some types of contingent arrangements in reserve will continue to be necessary, even with much a much stronger cross-border resolution process. The role of deposit insurance in stemming financial crises is well documented. A period of multiple financial institution failures, even with a strong resolution process, might trigger the same risk aversion in funding markets that we saw in 2008 and 2009. The ability to backstop key funding markets could prove valuable, and the Dodd-Frank Act preserved for the Fed authority under 13(3) to provide market liquidity facilities even while eliminating other aspects. But in designing these interventions, an exit strategy needs to be clear. Leaving those arrangements in place too long distorts incentives and erodes private market function.
And for those contingent arrangements that are ongoing, such as deposit insurance, measuring the value of the guarantee could be an important test of overall design of the guarantee and the accompanying monitoring regime. Continuing to refine our ability to value guarantees would provide a useful measure for supervisory authorities and for the deposit insurers, especially when they consider changes to deposit insurance. The value of guarantees also would complement other measures being developed for financial stability monitoring. Further, I suggest that all guarantees should not only be measured, but documented and reported, and not left as implicit.
Fourth, it will still be important to have a set of progressive actions that government can turn to if human judgment or the tools available at a time of incipient financial crisis prevent financial authorities from defusing the crisis. While such measures buy time and cannot substitute for more permanent solutions, sometimes time is the scarce resource. Deterioration in financial conditions--at individual financial institutions and in the economy—is inevitable as a crisis wears on in a financial system, given its leverage. Understanding that, financial authorities should feel great urgency to apply the progressive measures when they are needed, doing so with the force and size that truly arrest the crisis forces, and to entertain the usually difficult measures needed to resolve the fundamental problems behind the crisis.