Fed Reflects on Financial Crisis and Its Root Causes

The ongoing financial crisis started small, but continued to build on itself until it reached its zenith, according to studies released at the recent Federal Reserve Bank of Chicago conference on Bank Structure and Competition.

“The credit crisis that began in the summer of 2007 is a powerful reminder of the importance of financial market liquidity for macroeconomic stability,” said Arvind Krishnamurthy, author of Amplification Mechanisms in Liquidity Crises. The onset of the financial crisis resulted in the drop of market liquidity, funding liquidity and balance sheet liquidity, leading to a flight to liquidity by investors.

Investors buy secondary markets that are highly liquid, exiting portfolios that are illiquid, and prefer to hold portfolios in short-term, safe claims, such as bank claims that are de facto liquid, according to Krishnamurthy. So investors seek bank deposit, repurchase agreements and commercial paper that can be (relatively) easily bought and sold through banks and hedge funds.

As the crisis deepened, however, the intermediaries – the commercial banks, hedge funds, et al, cut back their lending in order to conserve cash and improve their balance sheets. This need for cash was compounded because consumers and corporate investors – seeing the need for cash themselves — withdrew their money, money that had provided the intermediaries with a very inexpensive source of funds.

Ran Dunchin, co-author of Costly External Finance, Corporate Investment and the Subprime Mortgage Credit Crisis, pointed out that corporate investment declined with the onset of the crisis, with the biggest declines in those firms with low cash reserves or high debt.

“A shock in one market tightens balance sheet constraints and causes liquidations and falling asset prices in other markets,” Krishnamurthy added. So the tightening of mortgage lending helped contribute to the tightening of other lending, like consumer credit. Credit providers are underinsured for such events, according to Krishnamurthy. He pointed to the relatively low volume (when compared to all credit) of defaulting subprime loans that turned out to be the tip of the iceberg. As subprime loans defaulted, the effects carried through the rest of the credit markets.

Dunchin added that the losses resulted in an increased interest in risk management by financial institutions and a sharp decline in lenders’ willingness to take on risk. So cash holdings in a portfolio were valued more highly than other investments. In fact, cash-rich firms can use such a crisis to increase market share.

Firms that rely most on external financing will be the slowest to emerge from the credit crisis as it wanes, according to Dunchin.

To help avoid a similar financial crisis in the future, Krishnamurthy recommends that regulators limit the leverage of the financial institutions and help ease any liquidity crises by absorbing less liquid assets into its balance sheet and providing more liquid, government-backed assets, such as Treasury bills and bonds, in return.