Bernanke Statement before Financial Crisis Inquiry Commission (2010) Vaughan / Economics 639 Fall 2015

Triggers vs. Vulnerabilities Triggers – Particular events or factors that touched off crisis. Vulnerabilities – Structural weaknesses in financial system and regulation/supervision that propagated/amplified initial shocks.

Triggers Major Trigger (i.e., most prominent) – Prospect of significant losses on residential-mortgage loans to subprime borrowers that became apparent shortly after house prices started declining. Minor Trigger – “Sudden stop” in June 2007 in syndicated lending to large, relatively risky corporate borrowers.

Vulnerabilities – Private Sector Dependence of “Shadow Banking System” on unstable, short-term, wholesale funding. “Shadow Banks” – Financial entities other than regulated depository institutions that channel savings into investment. Securitization vehicles, ABCP vehicles, money-market funds, investment banks, mortgage companies, etc. are part of the shadow banking system. Reliance of shadow banks on short-term uninsured funds made them subject to runs (which, in turn, led to “fire sales” of assets).

Vulnerabilities – Private Sector Deficiencies in risk management and risk controls - Examples include: Significant deterioration in mortgage-underwriting standards before crisis (not limited to subprime borrowers). Similar weakening of underwriting standards for commercial real estate. Excessive reliance by investors on credit ratings. Inability of large firms to trace firm-wide risk exposures (including off-balance sheet). Inadequate diversification by major financial firms.

Vulnerabilities – Private Sector Excessive leverage by households, businesses and financial firms. Derivatives: Apart from credit derivatives, played no role in the crisis. Throughout crisis, virtually all derivatives contracts were settled according to their terms (i.e., without incident). Credit derivatives (credit default swaps or CDSs) were a problem. AIG took large positions without hedging or providing adequate capital.

Vulnerabilities – Public Sector Statutory framework of financial regulation in place before crisis contained serious gaps. Most shadow banks were not subject to consistent and effective regulatory oversight (special purpose vehicles, ABCP vehicles, hedge funds, nonbank mortgage origination companies, etc.). Some shadow banks were subject to prudential oversight, but it was weak/inadequate (investment banks, AIG) Result: Lack of data that could have revealed risk positions/practices. MDV Aside: Will it ever be any different? Financial innovation will always be ahead of regulation. Also, Bernanke’s argument implicitly asks to give Fed more responsibility

Vulnerabilities – Public Sector Regulation/supervision focused on safety-and- soundness of individual firms/markets, not on systemic risk. Poor oversight of Freddie/Fannie. Were allowed to grow rapidly (in part through purchases of subprime MBSs) with inadequate/poor quality capital. Ineffective use of existing authority (especially by bank regulators). MDV Aside: Will it ever be different? (Concrete profits vs. “ bad feeling”)

Vulnerabilities – Public Sector Weak Crisis-Management Capabilities In contrast to regime for depository institutions, no one in U.S. government had legal authority to resolve failing nonbank financial institutions (including bank-holding companies) so that creditors would face appropriate losses, without producing significant systemic effects. MDV Aside: Lack of legal authority did not stop Fed when it came to dealing with Bear Stearns or creating novel liquidity facilities. “Too Big to Fail” Causes moral hazard. Gives competitive edge to large firms over small firms. TBTF firms can become systemic threats.

Causes of Housing Boom Not monetary policy. High rate of foreign investment in U.S. (savings glut). Feedback loop between optimism regarding housing prices and innovations in mortgage market. MDV Aside: Bernanke Admits nothing! “Too low” interest rates were not responsible for boom, and failure to loosen policy as economy crashed was not responsible for deep recession.