“Dudley and the Missing Lessons of the Financial Crisis”

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

On Friday, William Dudley, President of FRBNY, gave an excellent presentation on the financial crisis. The speech was a logically-structured, tightly-reasoned, and succinct retrospective of the crisis. It took one step back from the details and proved a very useful financial sector-wide perspective. The speech should be read by everyone with an interest in the crisis. It highlights the often overlooked role of leverage and maturity mismatches even as its stated purpose was examining the role of liquidity.

While most analysts attributed the crisis to either specific instruments, or elements of the de-regulation, or policy action, Dudley correctly identified the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system. The body of the speech opens with: “..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.” The speech goes on to document the shadow banking systems propensity to engage in maturity mismatches and reliance on short-term funding. The financial crisis is then explained in terms of the sometimes precipitous decline of funding, first from the shadow banking system and then more broadly.

Given the importance placed on the shadow banking system, the complete and total absence of any explanation or reference to the genesis and development of the shadow banking system is striking. It is as if the shadow banking system was a case of parentless, financial spontaneous generation. However, the shadow banking system, replete with short-term funding and maturity mismatches, had many “parents”. Two of the more important were:

1. Low short-term interests rates for an extended period of time which allowed for high risk-adjusted return on both leveraged positions and maturity mismatches.
2. The Basel banking regulations which made it much more efficient/profitable to run leverage maturity mismatches outside the confines of the regulated, traditional banking system.

Of course, noting this parentage would have made the proposed re-regulation-only responses to the crisis appear less than adequate. Charles Goodhart, formally of the BOE, gave a speech the day before that addressed some of the problems left unanswered by a re-regulation approach to preventing future crises. The speech presents a point of view that does not get much play in the press or among policymakers in the US.

Liquidity or the absence thereof was the focus of the Dudley’s speech. He noted how quickly the liquidity buffers at various broker/dealers were “exhausted” and how rapidly the problems spread. He proposed a number of remedies. Given the public good aspect of liquidity and the order of Dudley’s proposed remedies, it appears that the Fed’s first choice is to:

• outsource to the private sector the responsibility of supplying a public good,
• as it steps back from the traditional function of a central bank: lending freely to solvent institutions on the basis of adequate collateral.

The first two of Dudley’s proposed remedies require firms to hold more capital and maintain larger liquidity buffers. However, higher capital requirements and larger liquidity buffers will also incent firms to be on the other side of any new regulatory boundary—the son of the shadow banking system? The third is requiring greater transparency. Dudley’s fourth proposed remedy was that the regulators should expand access to a “lender of last resort” or other forms of liquidity backstops for a broader array of firms assuming solvency and adequate collateral. It should have been the first remedy.

No mention is made of any possible problems generated by insolvency of a systemically important institution. Perhaps time did not allow for a discussion of the issues this would entail. It should have at least been mentioned as the piece leaves the reader thinking that the crisis was just a liquidity event.

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  1. Toby

    Is that link to Mr Dudley’s speech a dud because of the author’s name, or is something more sinister afoot here?

  2. joebek

    “Low short-term interests rates for an extended period of time which allowed for high risk-adjusted return on both leveraged positions and maturity mismatches.” Might it be said that persistent low short-term interest rates cause over-leveraged, maturity mismatches in a competitive, capitalist economy? Can it not also be said that a rational expectation is that this condition will cause panic at some point?

  3. just some guy

    Dudley is a personal friend of Geithner.
    Yves goes to DC to be plied by Geithner, and in the following weeks starts peddling the official line.

    And you think your readership won’t notice you’ve been partially subverted?

    1. Yves Smith Post author

      I suggest you bother learning to read. It might prevent you from putting you foot in your mouth and chewing in public.

      Richard Alford, the author of this post, is a former Fed economist and has been regularly guest posting since the summer. The vast majority of his posts are critical of the Fed. So if you have a problem with the post, your problem is with him, not me.

  4. DownSouth

    There is something terribly flawed with Dudley’s analysis.

    More than anything else, it is a polemic to justify the actions–perhaps the most egregious of those being having the taxpayer act as “lender of last resort” or, to be more truthful, purveyor of unlimited “cash for trash” for the TBTF banks–of Team Obama.

    These guys like Dudley still believe (or at least are arrogant enough to believe they can convince a gullible public to believe) the fiction that their castles can be built upon sand.

    What makes this sophistry so beguiling is that is has just enough of an element of truth to it to make it plausible to the uninformed, for undoubtedly there were some problems caused by a lack of liquidity.

    But to jump from that to the implication that all problems were caused by a lack of liquidity is a half-truth at best, and an outright lie at worst.

    In Dudley’s twisted logic, where perception is king and reality counts for nothing, even balance sheet problems can be explained away by a lack of liquidity. “Once counterparties start to worry about liquidation,” he illustrates with his nice little charts, “the probability distribution can shift very quickly toward the insolvency line.”

    This is Alice-in-Wonderland stuff, where “exchange market” value is portrayed as having become “irrational,” and the underlying “use” value (excellent discussion by Jesse on this the other day) is of no importance whatsoever. What Dudley is of course really arguing for is that we ignore both market exchange value and use value, and have government be the arbiter of values—fixing them by fiat.

    So the end result is that we get no acknowledgement of what lies at the heart of the crisis, that it was abominable (and most likely illegal) lending practices that drove the “use” value of bank assets, and thus the value of the banks themselves, into oblivion.

    But of course, what do you expect from the president of the New York Fed?

    1. CDSnotWMD

      Perception is reality…

      This has been very well illustrated in Dudley’s speech. Or how do you think someone is recruited for a given position over someone else, how investment decisions are made, how business is conducted. In spite of all attempts to base decisions on objective criteria, there is always an element of perception involved.
      This is particularly relevant for the capital markets, which are driven by speculators and the Greater Fool theory nowadays.

  5. wunsacon

    Dudley’s 4th “proposed remedy” will undercut the others, because he’s “proposing” that we increase the expectation of future government bailouts to risk-takers who don’t offer enough transparency (on their own) to convince the market of their solvency.


  6. Siggy

    I just read Mr Dudley’s presentation. I see it as an apoligia for the course of action that the Fed took.

    As to point 4, the best course of action is to have a method of resolution in place for those occassions when the insolvent institution is sytemically significant; or, a ‘primary dealer’ bank.

    Mr. Dudley is an economist given to seeing what is. He is also an expatriot of Goldman Sachs. He may be a friendly acquaintance of Mr. Geithner; however, I suspect that he knows Mr. Paulson much better.

    The missing lesson has not yet been apprehended. The lesson not taken is that this balance sheet crisis derives from a fiat currency, a fractional reserve banking system, the abrogation of regulatory responsibility and a moral failure of epic proportion. All the other stuff is dross!

  7. kevin

    Ok, I’ve read the report (most of it).

    I’ll give you the laymens perspective:

    Short term financing dried up, creating liguidity crisis amongst financial institutions who did not want to become bagholders of the assets that everyone knew were crap to begin with.

    Is that about it?

  8. Doug Terpstra

    So, to summarize, the crisis was caused by interest-free Fed money to crony members and inadequate regulation by caputured regulators and legislators. A breakthrough revelation: cheap money and deregulation. Glad we’re fixing that; we wouldn’t want to repeat those mistakesl

    These again are just symptoms It seems Dudley Do-right might have taken just one step farther back and said something about real root causes: public bribery and legally sanctioned fraud. They really take us for fools.

  9. i on the ball patriot

    Oh vanilla greed you sorry ass loser you,
    Pernicious greed has cleaned your clocks,
    And stolen your slaves,
    And taken them to a deeper darker shadow plantation of greater evil and pain,
    And now you implore those very same slaves to help you,
    You attempt to arouse them to save you,
    You want them to return you to the vanilla greed plantation of yesteryear,
    So that you may again exploit them,
    And enslave them,
    In your own little self centered privatized world,
    Of aggregate generational corruption …

    Fuck you vanilla greed!

    Deception is the strongest political force on the planet.

  10. kevin

    ****“..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.” The speech goes on to document the shadow banking systems propensity to engage in maturity mismatches and reliance on short-term funding. The financial crisis is then explained in terms of the sometimes precipitous decline of funding, first from the shadow banking system and then more broadly.****

    How is this possible as an explanation?

    The crisis was caused by a rapid inflation of asset “pricing” that was not supported by the asset “value”.

    Everything else is simply an explanation of how the mechanism that allowed that to happen failed.

  11. Jon M

    Hi there, I note here you say ” It highlights the often overlooked role of leverage and maturity mismatches even as its stated purpose was examining the role of liquidity” –by which I take you to mean that Liquidity and Maturity Mismatch are two different things. Pedantically speaking you can be argued to be correct in that, since Maturity Mismatch usually refers to Repricing maturity rather than Rolloff maturity, but I suspect that Dudley was referring to rolloff maturity mismatch –which IS liquidity. So I am not sure that you quite understand what creates a Liquidity problem for a bank –it is that their liabilities roll off before their assets do –ie they have a Rolloff Maturity Mismatch. Which is I think what Dudley was talking about

    Interestingly, those few banks who had ever worried in the past about Liquidity seemed to give up on that around the early 1990s. Adopting a ‘Liquidity Strategy’ (which in turn leads to a ‘Liquidity Plan’ and a ‘Liquidity Crisis plan’ and should incorporate pricing and credit for use and creation of liquidity) became a thing of the past. Anyone telling a bank that they needed these things in the later 1990s or 2000s was, fomr what I could see, treated with total lack of interest and shown the door. However, the few banks who (to my knowledge) had done that even in the early 1990s did somehow do better all these years later than the banks that had never worried about Liquidity in the first place. Even now, I don’t hear of banks doing much about their Liquidity profile (except in the UK, and then only in response to the FSA’s recent demands –and I am not sure that too much is being done even by then).

    If there is a full economic recovery, and no ‘double dip’ big bang disaster over the next few years, then I predict that Liquidity will gradually disappear as a concern, and institutional memories will again disappear, and then there will be another disaster, in another 40 years’ time, when people have learnt to stop worrying about Liquidity. . . . .

  12. craazyman

    In contemplating Mr. Dudley’s remarks and general point of view, I am drawn in recollection to another encounter between an apostle of “commerce” and his interlocutor, the Marlow of Joseph Conrad’s Heart of Darkness.

    Yes, Marlow himself would no doubt find a metaphoric resonance in the methods of the Company of the 1890s Congo Ivory trade and the no-less violent (albeit less bloody) financial trade of our day. I see Mr. Dudley as a well-meaning strategist at Company headquarters, abstractly analyzing the body count and the methods employed by the trade to accomplish its business objectives, and lecturing an assembly of ivory trade senior management, in a genial and genteel way, on ways to reduce the collateral damage and gain efficiencies in the process — in short to improve “the method”.

    Kurtz himself, of course, is too high a bar for our time. None of the psychopaths who’ve been tossed onto our mind-screens by the GFC would seem to be even remotely capable of grasping Mr. Kurtz’s deeply existential and almost eschatological view of homo natura, or his capacity for trenchent metaphor. This might be something done to consciousness by the immersion through work in fleshless abstractions — such as “money” — instead of things that tap a sort of primal kinesthetic sensibility, like digging ivory and bringing it a thousand miles through a hot hell.

    Our proto-Kurtzes would be playing golf somewhere, or tanning themselves before getting a massage. Perhaps this is a form of progress, for which we should be grateful. Althought I’m inclined to think it’s merely a brief epiphenomenon of our enlightened “civilization”, which may be rendered as a form of nostalgia if this madness is unrestrained and runs its natural course.

    * * *

    But there is no disguising the fact, Mr. Kurtz has done more harm than good to the Company. He did not see the time was not ripe for vigorous action. Cautiously, cautiously — that’s my principle. We must be cautious yet. The district is closed to us for a time. Deplorable! Upon the whole, the trade will suffer. I don’t deny there is a remarkable quantity of ivory — mostly fossil. We must save it, at all events — but look how precarious the position is — and why? Because the method is unsound.’

    ‘Do you,’ said I, looking at the shore, ‘call it “unsound method?”

    ‘ ‘Without doubt,’ he exclaimed hotly. ‘Don’t you?’ . . .

    ‘No method at all,’ I murmured after a while.”

    -Joseph Conrad, Heart of Darkness

  13. Skippy

    Why do I get the feeling that the Fed is the East India Trading Co and our government the PR division and that they no longer wish to own the assets via physical extraction/exploitation, that now its through a fiat reserve currency status.

    Skippy…what a sweet game, no liability affixed to the actual goods all along the path to sale and after, just the skimming goodness planet wide. The Fed is a scam.

  14. michael

    I actually find Dudley’s first main factor LACK OF TRANSPARENCY much more important than the liquidity crisis.

    And you just got to love his recursive logic in:

    “The uncertainty stemmed, in part, from the lack of transparency about what prices these assets could be sold for, which, in turn stemmed from the difficulty of valuing these extremely complex and heterogeneous securities.”

  15. craazyman

    I think even Orwell himself would be amazed. Not at the phenomenon itself, but that it has reached such a stage of erudite refinement.

  16. Hugh

    “Dudley correctly identified the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system”

    Am I the only one (besides Siggy) to see the humor in this from the man who was Goldman’s chief economist while all this was going on? Or how laying off the exotic instruments and de-regulation is a way to direct attention away from Goldman and Dudley’s role in the crash?

    DownSouth pretty much nails it. All of this seems like going the long way round to say there was a bubble and surprise, it burst. But why this is the shadow banking system’s fault and not the bubble makers is unclear to me. Rather like saying so we had access to all this money so of course we had to go out and blow it on something really stupid.

  17. ndk

    Nary a mention of the real economy, or potential problems therein that could have affected the financial system. No concern about cash flows, underlying asset values, or defaults in the real economy. I guess that’s all perpendicular to the important stuff.

    I’m proud other commenters caught on to the omission of all that. I’m deeply bemused that you and Dudley didn’t.

    The mere existence of analysis like this is fascinating, in a meta- kinda way. I also find dadaism fascinating.

    1. ndk

      Oh, nor any mention of the spectacularly large current account deficit or the massive inflows of capital from currency pegs. But I guess that’s fine for a small, closed economy like that of the US.

      Seriously, to suggest you can “correctly identify the causes” and ignore the rest of this is incredibly arrogant. Geithner himself had pretty good a priori analysis of the impacts of petrodollar/Chinese trade flow recycling and its potential dangers.

      I happen to think currency recycling was a really big deal, in concert with a poor rate of return on investment in America(heavily distorted towards residential housing and in competition with a severely overdeveloped China), as well as maturity mismatches and leverage.

      But you brush two thirds of those away with a snort and focus entirely on… the domestic banking system.


    2. Skippy

      Did you say dadaism, my young spud!

      Let me show you the way: http://www.youtube.com/watch?v=cwtqf0RRWNY&feature=related

      The common stock, we put the poles in the holes: http://www.youtube.com/watch?v=whc60qlD5MU&feature=related

      Ipso facto I can’t get no: http://www.youtube.com/watch?v=eZXEVVX-RAw&feature=related

      Which makes me a Mongoloid: http://www.youtube.com/watch?v=ZWmf7r_37eA&feature=related

      Which make me want to twist away the gates of steel: http://www.youtube.com/watch?v=qz8QPL8_hLg&feature=related

      That leaves me with an: http://www.youtube.com/watch?v=ZRENoPisFYk&feature=related

      Well DownSouth how are the altruistic to fight the A’s of the world really..Good intentions?

      Bob you asked me a question one time concerning size of the prophet. Well what ever he had was chopped off even before he was born via the immaculate conception…eh…their is your nihilist novelette.

      Skippy…the dada bob, better than killing hay.

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