An investment boom preceded each panic – the earlier in copper and the later in housing – with much of the credit being funded by sources outside of any existing liquidity protections. When the bubbles began to deflate and prices began to fall, loan defaults quickly developed precipitating funding runs on the institutions involved in extending this credit. What seemed like large liquidity buffers by individual firms were quickly drawn down. Funding withdrawals precipitated asset sales, which put further downward pressure on asset prices. The resulting credit contractions adversely affected the real economy, setting up an adverse feedback loop that exacerbated the initial losses. 2  2  Walter Bagehot, 1873. Lombard Street. London: Henry S. King and Co.  BIS Review 92/2010  Given the parallels between the events of 1907 and 2007 and, more importantly, the similarities of the lessons learned from those episodes, I believe the most instructive name for our latest financial crisis is the “Panic of 2007”. In the rest of my remarks, I will explore in greater detail the factors behind the panic, as well as the responses by the Federal Reserve. The first question to explore is the extent to which the financial system had evolved over the past several decades. 3 Over this period, demand deposits lost their market share to money market mutual funds, which, while considered safe, are not guaranteed like deposits. This made it increasingly difficult and less profitable for banks to fund loans on their balance sheets using deposits.
Nout Wellink, President of the Basel Committee on Banking Supervision and Governor of the Central Bank of the Netherlands, quotes Charles Kindleberger, saying in his famous book "Manias, Panics and Crashes", that the "financial crises are typically a result of extended accumulation of imbalances preceded by certain exogenous shock, or structural changes in the financial system. The examples are in the changes in the political environment, new regulations and financial innovations. These changes create new possibilities, but also, uncertainties and lack of awareness of potential risks from the so-called unknown-unknowns". In such environment, says Wellink, "the traditional checks and balances can become inappropriate and can easily result in excessive risk". Really, we have faced:  2. 4  •  Fiscal and balance of payments deficits, which failed to be treated because there was no enough good will for that in the globalized world, and accordingly to discuss about the foreign exchange rates. •  Huge imbalances in the financial sector, the dimensions of which grew to explosion. While the savings rates were decreasing with a limited rise in the households' deposits being registered, the banks were filling in the gap between the retail deposits and the credit growth by using sources from the wholesale markets. For example, in England, the gap between the lending to clients and the deposits climbed from zero, in the beginning of the century, to over British Pounds 700 billion in the first half of 2008, says Sir John Gieve, Deputy Governor of the Bank of England.