William C Dudley: More lessons from the crisis Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Center for Economic Policy Studies (CEPS) Symposium, Princeton, New Jersey, 13 November 2009. *  *  *  Thank you for having me here to speak today. It is a real pleasure to have this opportunity to speak at CEPS again – this is a great forum to talk about policy issues. Tonight I want to discuss some of the challenges we face in making our financial system more robust. We have learned a great deal over the past two years about our financial system and its vulnerabilities. The task ahead is to put these lessons to good use. Our goal must be to make the financial system more resilient to shocks. If we can do that successfully, we should be able to reduce the risk of financial crises. In assessing the causes of this crisis, one clear culprit was the failure of regulators and market participants alike to fully appreciate the strength of the amplifying mechanisms that were built into our financial system. These mechanics exacerbated the boom on the way up and the bust on the way down. Only by better understanding the sources of these damaging dynamics can we construct solutions that will strengthen our financial system and make it more robust. Today, I am going to focus mainly on the extraordinary liquidity events that played out during this crisis.
For example, the Federal Reserve introduced the Commercial Paper Funding Facility (CPFF) to reduce rollover risk in the commercial paper market, the Federal Reserve and other central banks’ massively expanded the ability of banks to obtain dollar funding through the TAF and associated foreign exchange swap programs; the Treasury guaranteed money market mutual fund assets; and the FDIC increased deposit insurance limits and set up the Temporary Liquidity Guarantee Program (TLPG) to backstop bank and bank holding company debt issuance. Having described “what” happened on the liquidity front during the crisis, I next want to examine, in a bit more detail, “why” it happened. To do this, I will lay out a simple conceptual framework that I will then use to assess what can be done to mitigate the risk of such runs occurring in the future. As a starting point, I will talk about how unsecured lenders react in a crisis, and then I will consider the behavior of secured lenders. Unsecured liquidity providers run for two basic reasons. First, they run because there is a risk that the company they are lending funds to is insolvent. In other words, there is a risk that the assets will be worth less than the liabilities, creating the potential for loss to the creditor. The second reason that unsecured creditors run is the risk that they will not be repaid in a timely way.