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Why was the system so fragile?

Part of the explanation was the size of the global financial boom that preceded the crisis. The larger the boom, the greater the potential risk of damage when it deflates.

The underpinnings of this particular boom include a large increase in savings relative to real investment opportunities, a long period of low real interest rates around the world, the greater ease with which capital was able to flow across countries, and the perception of lower real and inflation risk produced by the greater apparent moderation in output growth and inflation over the preceding two decades.

This combination of factors put upward pressure on asset prices and narrowed credit spreads and risk premia, and this in turn encouraged an increase in leverage across the financial system.

This dynamic both fed and was fed by a wave of financial innovation. As the magnitude of financial resources seeking higher returns increased around the world, products were created to meet this demand. Financial innovation made it easier for this money to flow around the constraints of regulation and to take advantage of more favorable tax and accounting treatment.

The U.S. financial system created a lot of lower quality mortgage securities, many of which were packaged together with other securities into complex structured products and sold to institutions around the world. Many of these securities and products were held in leveraged money or capital market vehicles, and financed with substantial liquidity risk. And yet, by historical standards, the overall level of risk premia in financial markets remained extraordinarily low over this period.

The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets. In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.

here are three aspects of the latest set of changes which I think deserve more reflection.

The first is about the role of market liquidity and liquidity risk in how credit markets work. Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage.

U.S. financial institutions now hold only around 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in.
The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

A second issue we need to consider stems from the complexity of the new credit instruments, the challenges they present in terms of valuation and risk measurement and their short history of experience in times of stress.

Even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses. Default rates are harder to predict where there has been a substantial change in the financial attributes of borrowers. The prices of instruments may not respond as expected to a given change in losses or in the value of the assets underlying these instruments. Hedging strategies may prove to be less effective than expected. Similarly rated instruments can behave very differently in stress events.