The Reserve Primary Fund “broke the buck,” and investors rushed to withdraw their funds from prime institutional money market mutual funds in a modern version of a classic “bank run.” The funds generally did not have sufficient cash available to meet these runs because they offered overnight liquidity at par value against a portfolio of assets with weighted average maturities that were considerably longer. Another important source of instability was the large volume of bilateral OTC derivatives positions outstanding among the major firms and the right of a firm to immediately close out such positions if their counterparty became insolvent. For example, when Lehman Brothers failed in September 2008, counterparties to Lehman terminated OTC derivatives in which the contract was in the money (i.e., Lehman owed money to the counterparty) and liquidated the collateral held against 3/7  BIS central bankers' speeches  those obligations, but kept open obligations in which the exposure went the other way, from them to Lehman. Not only did this create an imbalance in the risk exposures of the failed firm, but it also generated significant market churn and risk as firms scrambled to rebalance their own risk exposures. The contagion generated by the complex web of outstanding bilateral OTC derivative exposures significantly worsened the crisis and was responsible for much of the losses Lehman incurred in its bankruptcy.2 The near-collapse of the U.S. financial system underscores three critical lessons. First, financial institutions must be robust to stress.
There are two essential requirements: the ability to initiate an effective resolution strategy over the weekend, and a government entity—be it the Federal Reserve or the FDIC—that can provide a credible liquidity backstop to the recapitalized entity when it opens for business on Monday morning. If resolution cannot be accomplished in this timeframe, confidence would suffer and there would be contagion. Without a credible liquidity backstop, clients and counterparties would run, making it much more difficult for the recapitalized firm to conduct its business. I would also preserve the authority of the FSOC to designate non-banking firms as systemically important and subject to supervision by the Federal Reserve. As I see it, the designations of GE Capital and AIG were successful in two important respects. First, Federal Reserve supervision resulted in improved corporate governance and risk management. Second, it created incentives for the firms to alter their operations to become less systemically important in order to be dedesignated. We should also retain this designation tool because we cannot predict which firms and activities may emerge and become systemically important in the future. After all, I do not think many were focused on or worried about the activities of AIG’s Financial Products Group several years before the financial crisis, though in retrospect those activities proved to be systemically important. That part of the firm should have been better supervised and regulated.