This book’s central concern is the fundamental stability of our financial system upon which the viability of our economy, and ultimately our polity, rests. This stability depends on the ability of the government, and especially our central bank, the Federal Reserve, to deal with panic runs—contagion—as it did during the financial crisis of 2008. The failure to do so in the future could put our country’s survival at risk. It could lead not only to a depression but could result in revolt—challenges to our political system itself. Our world power would be dealt a severe blow. The reserve status of our currency could well come to an end. A world crisis set off by a US depression would be a threat to our national security. Bad monetary policy might destroy a country in years, but bad lender of last resort policy can destroy a country in weeks.
In the aftermath of the crisis, those that saved our country during the crisis—the Fed, FDIC, and Treasury—were demonized as bailing out Wall Street. As a result the powers of the government to deal with contagion in the future have been severely constrained. This is not a popular subject to complain about—anyone, whether in industry or in government, seeking to restore and even improve our powers to deal with contagion will again be attacked as bailing out Wall Street. But given the stakes, this is no excuse for silence.
In the 2008 financial crisis we witnessed a severe plunge in real estate prices that led to significant losses for financial institutions exposed to residential mortgages and commercial real estate. This book demonstrates that it was “contagion,” not “connectedness,” that was the most potentially destructive feature of that crisis and that contagion remains the most virulent and important part of systemic risk still facing the financial system today. Connectedness is the possibility that the failure of one institution would bankrupt other institutions directly overexposed to them, resulting in a chain reaction of failures. Contagion is an indiscriminate run on financial institutions that can render them insolvent due to fire sales of assets necessary to fund withdrawals.
The book shows that connectedness was not the problem in the crisis. No significant Lehman counterparties were rendered insolvent by Lehman’s failure, with the exception of the Reserve Primary Fund where investors only lost a few pennies on a dollar. And no significant counterparties would have been rendered insolvent by AIG’s failure. This is because sophisticated financial institutions routinely manage counterparty risk by limiting their capital exposure, demanding adequate collateral, or hedging. Yet Dodd–Frank is largely premised on the idea that connectedness was the major problem in the crisis. This is reflected in Dodd–Frank’s requirements for central clearing of over-the-counter derivatives (swaps), net exposure limits for banks, and the designation of banks and other financial institutions as systemically important financial institutions (SIFIs) and therefore subject to heightened supervision by the Federal Reserve.
However desirable these Dodd–Frank policies may be, the real problem in the crisis was the contagion that smoldered before Lehman’s failure and broke out in a full blaze afterward. The losses from contagion and the impact on our economy and country would have been much worse but for heroic efforts by the Federal Reserve to expand its role as lender of last resort, by the FDIC to expand the amount of its insurance, by the Treasury to temporarily guarantee the money market funds, and by the government under TARP to make capital injections in some major banks that were insolvent, or on the brink of insolvency. But the powers of the Fed, FDIC, and Treasury were barely adequate to the task. While the lesson of the crisis should have been that Congress must strengthen their powers, its actual response was to weaken them.
The Federal Reserve was created in 1913 to stem such panics, which were rife in the nineteenth century and culminated in the panic of 1907, through acting as the lender of last resort. As the book describes, the United States came late to the party in creating a central bank. This was largely because of the bad political odor left by our early experiment from 1791 to 1832 with the First and Second National Banks. These were both full-scale federal banks (private in form but government controlled) with broad powers to lend commercially, not just to other banks. But these two National Banks could and did come to the aid of illiquid state banks by modulating use of their ownership of state bank notes to demand specie redemptions from the state banks. The National Banks came to an end in 1832 when newly reelected President Jackson, who had campaigned against these banks as too powerful and too federal, refused to back reauthorization. This bad odor is still with us. The current attack against the Fed’s power as lender of last resort is often premised on the idea that the federal government should not make any loans to the private sector, whether those loans are made to commercial establishments, banks or other financial institutions.
As a result of the anti-bailout sentiment following the 2008 crisis, the Fed’s power as lender of last resort was significantly restricted by the Dodd–Frank Act, particularly as a lender of last resort to nonbanks under Section 13(3) of the Federal Reserve Act. Having a strong lender of last resort for nonbanks is increasingly important, as nonbanks have issued approximately 60 percent of the estimated $7.4 to $8.2 trillion in runnable short-term liabilities in the financial system.
The Fed can now only lend to nonbanks under a broad program, only with the approval of the Secretary of the Treasury, only if the nonbanks are solvent, and only with heightened collateral requirements. The Fed must also make prompt disclosure of any loans to nonbanks to leaders in the Congress. Discount window loans to banks can also no longer be used to fund nonbank affiliates of banks like broker-dealers. Moreover the Fed knows that any future use of its powers a lender of last resort will be controversial, further threatening its independence and powers. This may inhibit its willingness to act in the future, even within the scope of its newly restricted legal powers.
It is eye opening that the Fed ranks last in its lender of last resort powers to nonbanks as compared to its peer central banks, the Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BOJ). None of these institutions differentiate their lending powers between banks and nonbanks or are prohibited from lending to single nonbanks. None have as demanding disclosure policies as the Fed. The ECB has what amounts to constitutional independence, and while the BoE and BOJ require Treasury approval or request for emergency lending, both operate in parliamentary democracies where the government also controls the Parliament. The biggest threat to Fed independence is the Congress (which can create and destroy the Fed), and which the Administration (even if of the same party) cannot control.
The Fed’s main partner in fighting contagion during the 2008 crisis was the FDIC, which was created in 1933 during the Depression. The fundamental idea behind its creation, which remains valid today, was that depositors in banks would not run if their deposits were insured. During the 2008 crisis the FDIC expanded the amount of insurance—granting unlimited insurance to transaction accounts and higher limits for other accounts. The FDIC also guaranteed the issuance of senior debt. In addition the Treasury stepped forward to temporarily guarantee the money market funds, where the contagion blaze first broke out. These FDIC powers were taken away by Dodd–Frank, and, in the case of the Treasury, by the earlier TARP legislation.
Some argue that the old powers to fight contagion are no longer necessary because we have put in place new ex ante regulations to prevent future contagion—namely enhanced capital requirements, new liquidity requirements, and new resolution procedures, what I have termed the two wings and prayer approach. Capital and liquidity requirements, the wings, are ex ante policies designed to prevent contagion, not to deal with it if it does occur. It would be foolhardy to believe we can completely avoid contagion by adopting such policies. Capital requirements only apply to banks and a few specific nonbanks (e.g., the three nonbank SIFIs, for which the requirements have not yet been determined), and could never be at a high enough level to assure short-term creditors that capital would not be seriously eroded by the fire sale of assets in a crisis. In addition the very methodology for designing capital requirements, whether through Basel requirements or stress tests geared to risk, is under serious attack.
New liquidity rules also only apply to banks, whereas short-term liabilities are increasingly held outside the banking system. Liquidity requirements seek to assure that banks have liquid assets to cover withdrawals in a run. But they are based on dubious assumptions about the withdrawal rates of different kinds of bank funding, and ultimately cannot avoid the need of a central bank to act as a lender of last resort when “private” liquidity fails. At best liquidity requirements can buy some breathing room for the central bank to determine what to do, but the fact of the matter is that it must act very quickly.
New resolution authority under the Orderly Liquidation Authority (“OLA”) in Dodd–Frank is the prayer. First, its use is not assured. It only comes into play if a financial institution on the brink of insolvency is determined to be a threat to the financial stability of the United States. Second, while procedures are being designed with the objective of making sure no short-term creditors of banks and other subsidiaries of financial holding companies, like broker-dealers, would lose money in an OLA procedure (as opposed to equity and longer term debt), these procedures may not prove effective or credible enough to stop runs on still solvent institutions. Short-term creditors may flee these institutions because they believe it is better to be safe than sorry.
Money market fund reforms, which include a floating NAV for prime institutional and municipal funds, and the powers of fund boards to impose liquidity fees or stop redemptions, are also inadequate to address contagion in that industry. Indeed the prospect of liquidity fees and redemption fees will only accelerate runs. Runs on money market funds can only be stopped the way they were in the crisis, by guarantees and a lender of last resort.
Some have proposed yet another ex ante policy to stop contagion, directing the short-term funding of the financial system away from the private sector into the public sector, because holders of public short-term debt would not run. The problem with this solution is whether it could be adopted on a sufficient scale, both within and outside the banking system, to eliminate the risk of contagion. This seems unlikely given the $7.4 to $8.2 trillion total size of runnable short-term debt, here defined as 30 days or less. Redirection of this amount of short-term funding to the Federal Reserve, through setting adequate rates to attract these funds, could conflict with monetary policy objectives. On the left-hand side of the Fed’s balance sheet it would raise credit allocation concerns—in what assets would the Fed invest its massively expanded balance sheet, and on the right-hand side it would raise fairness issues—from what private investors would the Fed accept funds. This approach would therefore inject the Fed into even a greater role in controlling our economy, a prospect unacceptable to many. Although this approach deserves further consideration, it is for now just a dream to go along with two wings and a prayer. Ex ante policies alone, including heightened macroprudential regulation, will be insufficient to manage the next crisis. Strengthening ex ante policies is no reason to weaken ex post protections.
Strengthening the contagion fighting powers described throughout this book would enable the government to credibly allow a large financial institution to fail. This is because such a failure would not spark contagion, as the market could rest assured that the government had the necessary authorities in place to protect the remaining solvent financial institutions. Thus strengthening the contagion fighting powers would actually reduce moral hazard, since the government would no longer have to “bail out” a large insolvent financial institution out of fear that contagion could spread to solvent financial institutions. Nonetheless, a strong lender of last resort should operate under a well-defined framework—such specification of actions that might be taken in a contagious panic could well forestall the panic in the first place and there is a need for the Fed to be transparent and accountable without weakening its ability to deal with crisis.
The last part of the book is focused on TARP, which is properly described as a bail out. In the end the government invested about $250 billion in capital in troubled financial institutions (out of a $700 billion authorization), starting with the nine largest banks and the refinancing of the Fed’s position in AIG. The taxpayer actually made money from this venture, as banks have more than repaid their investments.
Authority to make new investments in banks, post-2010, no longer exists. However, in a severe future financial crisis, involving the insolvency of a large number of financial institutions, bailouts and the invention of a new TARP would again be necessary. Without such an intervention the financial system would stop working and the real economy would plunge into a depression. We are fooling ourselves to believe that such a widespread insolvency will never occur. Of course, this could involve financial institutions of any size, so long as the insolvency is sufficiently widespread that the financial system seizes up. Resolution procedures can deal with restructuring insolvent institutions but cannot assure that they will remain solvent or be strong or big enough to continue to finance the economy. Both the Eurozone and Japan have standing TARP-like authority, and Congress should enact such an authority, whether or not it is pre-funded. We have learned many lessons from how TARP operated and we should put a better-designed TARP on the shelf, only to be used in dire future circumstances and with the highest levels of approvals, perhaps even a resolution of Congress.
There is one strong argument that restoring the government’s contagion fighting powers is unnecessary—that is, if we are looking over the precipice, as we were in 2008, then the Secretary of the Treasury, Federal Reserve and the Congress will do the right thing. While this is possible, as the Federal Reserve could use its Section 13(3) authorities, with the agreement of the Treasury, to lend to a wide range of financial institutions, we take a big risk that by the time the precipice is cleared, it will already be too late. Can the Federal Reserve convince the Secretary of Treasury that there is a precipice before a run has started and perhaps gotten out of control? The Secretary and the Fed will have to contend with restrictions that they cannot get around, like the express prohibition of lending to an insolvent institution, heightened collateral requirements and prompt disclosure to Congress. We do not want a system where we have to approach a precipice—we want a clear and strong deployment of weapons long in advance. This was not even possible under the old Section 13(3). And remember there is nothing that the Secretary and the Fed chair can do alone to deploy guarantees or a new TARP. Both require congressional action, and those voting yes on these measures will be putting their political future in jeopardy just as many democrats did when they voted for TARP in 2008.
One of the most challenging aspects of writing this book is knowing that those in and out of the government privately agree with many of my conclusions, particularly the need for Congress to strengthen the lender of last resort and establish a stronger guarantee system, but will not speak out for fear of being accused of trying to bail out Wall Street. However, this issue involves the very preservation of our country, with its economy, way of life, and role in the world. Our leaders need to speak out on this issue, even recognizing that there may be serious adverse consequences to their own careers or institutions. We need profiles in courage not fear.