The growing reliance on short-term wholesale funding to finance longer-term assets increased liquidity and maturity mismatch risk. This was particularly dangerous because many of the assets being financed were structured-credit products, some of which were opaque, difficult to value and illiquid. Short-term funding of longer-term assets is inherently unstable particularly in the presence of information and coordination problems. It can be rational for a provider of funds to supply funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the firm’s continued ability to roll over its funding from other sources. But if the use of short-term funding becomes sufficiently widespread, the firm’s roll-over risk increases. In this situation, there is a strong incentive for each lender to “run” if there is any uncertainty that could undermine the borrower’s ability to continue to roll over its funding from other sources. This is the case even if the provider of funds believes that the borrower would remain solvent as long as it retained access to funding on normal terms. Of course, this insight is not a new one. Prior to the establishment of a lender of last resort and retail deposit insurance for banks – which came with the quid pro quo of prudential regulation – bank runs were a regular and disruptive feature of our financial system. These innovations solved the coordination problem and stabilized this source of funding.
William C Dudley: Fixing wholesale funding to build a more stable financial system Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York and Chairman of the Committee on the Global Financial System (CGFS), at the New York Bankers Association’s 2013 Annual Meeting and Economic Forum, New York City, 1 February 2013. *  *  *  As prepared for delivery. Thank you for having me here to speak today. As you all know from daily experience, the financial system plays an essential role in modern economies. Because financial intermediation is critical to economic activity, disruption to it can cause severe damage to the economy. The experience of recent years revealed serious flaws in the system. Risk was mispriced and there was a build-up of excesses before the crisis. Structural weaknesses in the financial system then amplified the effect of the bursting of the bubble in U.S. house prices, and the result was a widespread financial crisis. One critical factor was the extensive use of short-term wholesale funding in the years leading up to the crisis. Not only did this aspect of our financial system create the potential for a firm to fail in an extraordinarily rapid manner when faced with a loss of market confidence, but it also served as a channel through which the effects of those failures were widely propagated throughout the broader financial system.