Geithner: At heart of crisis were repos and shadows

Geithner

At the heart of a ‘very severe and complex financial crisis” were runs on the repurchase market and the shadow banking system, Federal Reserve Bank of New York President Timothy F. Geithner told The Economic Club of New York June 9.

To reduce “systemic risk in a dynamic financial system,” comprehensive changes to regulation in the U.S. should be considered, Geithner said. Just making changes to capital, or equity, requirements will not be enough. he said.

It is going to require significant changes to the way we regulate and supervise financial institutions, changes that go well beyond adjustments to some of the specific capital charges in the existing capital requirement regime for banks.

Geithner spent some time answering the question, “Why was the system so fragile?”

From his speech:

The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets.

In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.

In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.

This parallel system financed some of these very assets on a very short-term basis in the bilateral or triparty repo markets. As the volume of activity in repo markets grew, the variety of assets financed in this manner expanded beyond the most highly liquid securities to include less liquid securities, as well. Nonetheless, these assets were assumed to be readily sellable at fair values, in part because assets with similar credit ratings had generally been tradable during past periods of financial stress. And the liquidity supporting them was assumed to be continuous and essentially frictionless, because it had been so for a long time.

The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks.

Once the investors in these financing arrangements—many conservatively managed money funds—withdrew or threatened to withdraw their funds from these markets, the system became vulnerable to a self-reinforcing cycle of forced liquidation of assets, which further increased volatility and lowered prices across a variety of asset classes.

In response, margin requirements were increased, or financing was withdrawn altogether from some customers, forcing more de-leveraging. Capital cushions eroded as assets were sold into distressed markets. The force of this dynamic was exacerbated by the poor quality of assets—particularly mortgage-related assets—that had been spread across the system.

This helps explain how a relatively small quantity of risky assets was able to undermine the confidence of investors and other market participants across a much broader range of assets and markets.

Banks could not fully absorb and offset the effects of the pullback in investor participation—or the “run”—on this non-bank system, in part because they themselves had sponsored many of these off-balance-sheet vehicles. They had written very large contingent commitments to provide liquidity support to many of the funding vehicles that were under pressure. They had retained substantial economic exposure to the risk of a deterioration in house prices and to a broader economic downturn, and as a result, many suffered a sharp increase in their cost of borrowing.

The funding and balance sheet pressures on banks were intensified by the rapid breakdown of securitization and structured finance markets. Banks lost the capacity to move riskier assets off their balance sheets, at the same time they had to fund, or to prepare to fund, a range of contingent commitments over an uncertain time horizon.

The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles. The system appeared to be more stable across a broader range of circumstances and better able to withstand the effects of moderate stress, but it had become more vulnerable to more extreme events. And the change in the structure of the system made the crisis more difficult to manage with the traditional mix of instruments available to central banks and governments.