Federal Reserve Chairman Ben S. Bernanke said the central bank must increase its focus on maintaining financial stability in order to prevent a repeat of the crisis that triggered the worst recession since the 1930s.
“The events of the past few years have forcibly reminded us of the damage that severe financial crises can cause,” Bernanke said in a speech today in New York. “Going forward, for the Federal Reserve as well as other central banks, the promotion of financial stability must be on an equal footing with the management of monetary policy as the most critical policy priorities.”
The remarks expand on a defense of the central bank’s aggressive response to the 2007-2009 financial crisis and recession that Bernanke gave in a university lecture last month and in previous speeches. Bernanke, who didn’t address the outlook for the economy or monetary policy in his remarks, has cautioned that “it’s far too early to declare victory” on the recovery.
“To avoid or at least mitigate future panics, the vulnerabilities that underlay the recent crisis must be fully addressed,” Bernanke said today at a conference titled “Rethinking Finance” organized by the Russell Sage Foundation and the Century Foundation. “This process is well under way at both the national and international levels.”
Responding to audience questions after the speech, Bernanke said evidence is “weak” that low central bank interest rates contributed to the housing bubble.
Bernanke devoted his speech to recounting the crisis and explaining the Fed’s actions to the public as it has come under scrutiny by critics in Congress and on the campaign trail.
Following the bankruptcy of Lehman Brothers Holdings Inc. in 2008, the central bank flooded the financial system with liquidity, expanding its balance sheet to $2.3 trillion by December of that year from $900 billion in September.
Even as the crisis ebbed, the recession deepened, with gross domestic product shrinking at an 8.9 percent annual rate in the fourth quarter of 2008, the worst quarter in 50 years. The unemployment rate rose to 10 percent in October 2009, the highest since June 1983.
Bernanke drew a distinction between triggers of the crisis, such as subprime mortgages, and vulnerabilities of the financial system that amplified their impact.
The vulnerabilities explain why the estimated $1 trillion in subprime mortgages, or the almost $7 trillion in wealth wiped out by the 30 percent drop in housing prices, had a far larger impact than the $8 trillion in losses caused by the Internet stock bubble, he said.
One key vulnerability was reliance on the so-called shadow banking system, which includes money-market mutual funds and markets for asset-backed commercial paper and repurchase agreements.
Other vulnerabilities included poor risk management by financial firms, inadequate diversification of risk, high leverage and dependence on short-term funding.
“Critically, shadow banking activities were, for the most part, not subject to consistent and effective regulatory oversight,” he said. “Even when the relevant statutory authorities did exist, they were not always used forcefully or effectively enough by regulators and supervisors, including the Federal Reserve.”
A broader failing, he said, was that no government agency had a mandate or authority to limit risks to the financial system as a whole.
Now, “we’re taking the shadow banking issue very seriously,” Bernanke said in response to a question. The Fed is also using so-called stress tests to push financial firms to better understand the riskiness of their investments.
“As supervisors and regulators, in the first instance we want to make sure firms are in a position where they can tolerate a major shock,” Bernanke said.
The financial system came under pressure in the summer of 2007 as the market for subprime mortgage bonds began to collapse, and by August the Fed responded by cutting the interest rate it charges on loans to banks borrowing at its discount window.
The Fed lowered its benchmark interest rate in a series of cuts, to 3 percent in January 2008 from 5.25 percent in August 2007. Yet in March 2008, the crisis intensified with the collapse of Bear Stearns Cos., the fifth-biggest U.S. securities firm, prompting the Fed to intervene and help JPMorgan Chase & Co. acquire the bank.
That didn’t end the crisis. In September 2008, Lehman Brothers filed the largest bankruptcy in U.S. history after the central bank and U.S. Treasury declined to intervene. One day later, the Fed made an $85 billion loan to American International Group Inc. to avert the collapse of the New York- based insurance company.
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