“Dudley and the Missing Lessons of the Financial Crisis”

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

On Friday, William Dudley, President of FRBNY, gave an excellent presentation on the financial crisis. The speech was a logically-structured, tightly-reasoned, and succinct retrospective of the crisis. It took one step back from the details and proved a very useful financial sector-wide perspective. The speech should be read by everyone with an interest in the crisis. It highlights the often overlooked role of leverage and maturity mismatches even as its stated purpose was examining the role of liquidity.

While most analysts attributed the crisis to either specific instruments, or elements of the de-regulation, or policy action, Dudley correctly identified the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system. The body of the speech opens with: “..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.” The speech goes on to document the shadow banking systems propensity to engage in maturity mismatches and reliance on short-term funding. The financial crisis is then explained in terms of the sometimes precipitous decline of funding, first from the shadow banking system and then more broadly.

Given the importance placed on the shadow banking system, the complete and total absence of any explanation or reference to the genesis and development of the shadow banking system is striking. It is as if the shadow banking system was a case of parentless, financial spontaneous generation. However, the shadow banking system, replete with short-term funding and maturity mismatches, had many “parents”. Two of the more important were:

1. Low short-term interests rates for an extended period of time which allowed for high risk-adjusted return on both leveraged positions and maturity mismatches.
2. The Basel banking regulations which made it much more efficient/profitable to run leverage maturity mismatches outside the confines of the regulated, traditional banking system.

Of course, noting this parentage would have made the proposed re-regulation-only responses to the crisis appear less than adequate. Charles Goodhart, formally of the BOE, gave a speech the day before that addressed some of the problems left unanswered by a re-regulation approach to preventing future crises. The speech presents a point of view that does not get much play in the press or among policymakers in the US.

Liquidity or the absence thereof was the focus of the Dudley’s speech. He noted how quickly the liquidity buffers at various broker/dealers were “exhausted” and how rapidly the problems spread. He proposed a number of remedies. Given the public good aspect of liquidity and the order of Dudley’s proposed remedies, it appears that the Fed’s first choice is to:

• outsource to the private sector the responsibility of supplying a public good,
• as it steps back from the traditional function of a central bank: lending freely to solvent institutions on the basis of adequate collateral.

The first two of Dudley’s proposed remedies require firms to hold more capital and maintain larger liquidity buffers. However, higher capital requirements and larger liquidity buffers will also incent firms to be on the other side of any new regulatory boundary—the son of the shadow banking system? The third is requiring greater transparency. Dudley’s fourth proposed remedy was that the regulators should expand access to a “lender of last resort” or other forms of liquidity backstops for a broader array of firms assuming solvency and adequate collateral. It should have been the first remedy.

No mention is made of any possible problems generated by insolvency of a systemically important institution. Perhaps time did not allow for a discussion of the issues this would entail. It should have at least been mentioned as the piece leaves the reader thinking that the crisis was just a liquidity event.