William C Dudley: Lessons learned from the financial crisis Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Eighth Annual BIS Conference, Basel, 3 July 2009. *  *  *  In assessing the lessons of the past two years, I will focus on five broad themes that are interrelated: •  Interconnectedness of the financial system  •  System dynamics – How does the system respond to shocks? •  Incentives – Can we improve outcomes by changing incentives? •  Transparency  •  How should central banks respond to asset bubbles? As always, my views are my own and may not necessarily reflect those of the FOMC or the Federal Reserve System. Interconnectedness This financial crisis has exposed how important the interconnections are among the banking system, capital markets, and payment and settlement systems. Focus on only one part of the financial system can obscure vulnerabilities that may prove very important. For example, the disruption of the securitization markets caused by the poor performance of highly-rated debt securities, led to significant problems for major financial institutions. Banks had to take assets back on their books; backstop lines of credit were triggered; and banks could no longer securitize loans, increasing the pressure on their balance sheets. This reduced credit availability, which increased the downward pressure on economic activity, which caused asset values to decline further, increasing the degree of stress in the financial system.
I don’t have any great ideas on how to address this, but it is a problem that needs to be fixed. •  Collateral and haircuts. When volatility rises and that leads to increased haircuts, the result can be a vicious cycle of forced asset sales, higher volatility and still higher haircuts. •  Compensation tied to short-term revenue generation, rather than long-term profitability over the cycle. This causes risk-takers to take on too much risk because they are compensated on the upside. This extends the boom. Incentives Incentives may be very important in determining whether we have a system that is dampening rather than amplifying. I think bad outcomes are not just about bad luck, they are also about bad incentives. The problem with incentives may be due to faulty compensation schemes, poor risk management or the fact that participants do not bear the full costs of their actions. One problem that we had in the U.S. banking system over the past year was a reluctance of banks to raise sufficient capital to be able to withstand bad states of nature. They didn’t want to do this because this might unnecessarily dilute their shareholders. As a result, many banks did not hold sufficient capital and market participants knew this. This led to tighter financial and credit conditions, which made the bad state of the world more likely. This is an example of both bad incentives and an amplifying mechanism.