The bottom line is that the entire system was suffering from a self-reinforcing cycle of liquidity runs and concerns about the solvency of financial institutions. An effective policy response had to address both aspects of this cycle. Responding to the demand for dollar liquidity It took government actions on many fronts to stabilize the financial system. Many of these efforts were aimed at addressing the solvency problems facing the financial sector, including the injection of capital into financial institutions and two of the housing GSEs. These efforts were critically important to the recovery of financial markets. However, l will focus my remarks on another important part of the government response – the actions taken by central banks and other government entities to address the liquidity strains in the markets. Central banks around the world responded vigorously to the erosion of liquidity conditions. The lender-of-last-resort function of central banks proved to be critical for supporting market functioning and stemming contagion. For the Federal Reserve, this function had to evolve in response to the nature and location of the liquidity disruptions it sought to address. The Fed’s traditional lender-of-last-resort tools are designed to ensure adequate liquidity for depository institutions. But the liquidity strains went beyond the banking sector and into the market-based credit system. The traditional tools were not adequate to address the problems faced in this more complicated intermediation system, and hence the Fed had to innovate – under extreme market conditions and with little time to spare.
While some of the innovations were still aimed at depository institutions, most of the facilities introduced were intended to address liquidity pressures at sets of firms in various financial markets, including primary dealers, money market mutual funds, commercial paper issuers and holders of asset-backed securities. In the end, these facilities effectively backstopped many of the different components of the shadow banking system. The efforts to ensure that the system had adequate liquidity also involved other government programs, such as the Federal Deposit Insurance Corporation’s (FDIC) debt guarantee and  4  BIS Review 40/2010  the U.S. Treasury Department’s money market guarantee. Those programs in effect broadened the insurance provided by the FDIC on bank deposits to other liabilities in the banking and shadow-banking systems. The combination of the liquidity and guarantee programs was instrumental in stabilizing the financial system. It is also worth noting that the demand for dollar funding proved to be global in nature, as financial institutions around the world faced an elevated need for dollar funding in response to market stress. This need was met by the liquidity swap lines that the Federal Reserve set up with fourteen central banks around the world. These swap lines provided dollar funding to foreign central banks so that they could inject dollar funding into their own markets, in order to address the funding demands of institutions operating during their market hours.