The Policy Response
Authorities in the United States and around the globe moved quickly to respond to this new phase of the crisis, although the details differed according to the character of financial systems. The financial system of the United States gives a much greater role to financial markets and to nonbank financial institutions than is the case in most other nations, which rely primarily on banks.4 Thus, in the United States, a wider variety of policy measures was needed than in some other nations.
In the United States, the Federal Reserve established new liquidity facilities with the goal of restoring basic functioning in various critical markets. Notably, on September 19, the Fed announced the creation of a facility aimed at stabilizing money market mutual funds, and the Treasury unveiled a temporary insurance program for those funds. On October 7, the Fed announced the creation of a backstop commercial paper facility, which stood ready to lend against highly rated commercial paper for a term of three months.5 Together, these steps helped stem the massive outflows from the money market mutual funds and stabilize the commercial paper market.
During this period, foreign commercial banks were a source of heavy demand for U.S. dollar funding, thereby putting additional strain on global bank funding markets, including U.S. markets, and further squeezing credit availability in the United States. To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies.6 In further coordinated action, on October 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points.
The failure of Lehman Brothers demonstrated that liquidity provision by the Federal Reserve would not be sufficient to stop the crisis; substantial fiscal resources were necessary. On October 3, on the recommendation of the Administration and with the strong support of the Federal Reserve, the Congress approved the creation of the Troubled Asset Relief Program, or TARP, with a maximum authorization of $700 billion to support the stabilization of the U.S. financial system.
Markets remained highly volatile and pressure on financial institutions intense through the first weeks of October. On October 10, in what would prove to be a watershed in the global policy response, the Group of Seven (G-7) finance ministers and central bank governors, meeting in Washington, committed in a joint statement to work together to stabilize the global financial system. In particular, they agreed to prevent the failure of systemically important financial institutions; to ensure that financial institutions had adequate access to funding and capital, including public capital if necessary; and to put in place deposit insurance and other guarantees to restore the confidence of depositors.7 In the following days, many countries around the world announced comprehensive rescue plans for their banking systems that built on the G-7 principles. To stabilize funding, during October more than 20 countries expanded their deposit insurance programs, and many also guaranteed nondeposit liabilities of banks. In addition, amid mounting concerns about the solvency of the global banking system, by the end of October more than a dozen countries had announced plans to inject public capital into banks, and several announced plans to purchase or guarantee bank assets. The comprehensive U.S. response, announced on October 14, included capital injections into both large and small banks by the Treasury; a program which allowed banks and bank holding companies, for a fee, to issue FDIC-guaranteed senior debt; the extension of deposit insurance to all noninterest-bearing transactions deposits, of any size; and the Federal Reserve’s continued commitment to provide liquidity as necessary to stabilize key financial institutions and markets.8
This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on October 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed. For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalized pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary. In the United States, support packages were announced for Citigroup in November and Bank of America in January. Broadly similar support packages were also announced for some large European institutions, including firms in the United Kingdom and the Netherlands.9
Although concerted policy actions avoided much worse outcomes, the financial shocks of September and October nevertheless severely damaged the global economy starkly illustrating the potential effects of financial stress on real economic activity. In the fourth quarter of 2008 and the first quarter of this year, global economic activity recorded its weakest performance in decades. In the United States, real GDP plummeted at nearly a 6 percent average annual pace over those two quarters an even sharper decline than had occurred in the 1981-82 recession. Economic activity contracted even more precipitously in many foreign economies, with real GDP dropping at double-digit annual rates in some cases. The crisis affected economic activity not only by pushing down asset prices and tightening credit conditions, but also by shattering household and business confidence around the world.
In response to these developments, the Federal Reserve expended the remaining ammunition in the traditional arsenal of monetary policy, bringing the federal funds rate down, in steps, to a target range of 0 to 25 basis points by mid-December of last year. It also took several measures to further supplement its traditional arsenal. In particular, on November 25, the Fed announced that it would purchase up to $100 billion of debt issued by the housing-related GSEs and up to $500 billion of agency-guaranteed mortgage-backed securities, programs that were expanded substantially and augmented by a program of purchases of Treasury securities in March.10 The goal of these purchases was to provide additional support to private credit markets, particularly the mortgage market. Also on November 25, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). This facility aims to improve the availability and affordability of credit for households and small businesses and to help facilitate the financing and refinancing of commercial real estate properties. The TALF has shown early success in reducing risk spreads and stimulating new securitization activity for assets included in the program.
Foreign central banks also cut policy rates to very low levels and implemented unconventional monetary measures. For example, the Bank of Japan began purchasing commercial paper in December and corporate bonds in January. In March, the Bank of England announced that it would purchase government securities, commercial paper, and corporate bonds, and the Swiss National Bank announced that it would purchase corporate bonds and foreign currency. For its part, the ECB injected more than 400 billion of one-year funds in a single auction in late June. In July, the ECB began purchasing covered bonds, which are bonds that are issued by financial institutions and guaranteed by specific asset pools. Actions by central banks augmented large fiscal stimulus packages in the United States, China, and a number of other countries.
On February 10, Treasury Secretary Geithner and the heads of the federal banking agencies unveiled the outlines of a new strategy for ensuring that banking institutions could continue to provide credit to households and businesses during the financial crisis. A central component of that strategy was the exercise that came to be known as the bank stress test.11 Under this initiative, the banking regulatory agencies undertook a forward-looking, simultaneous evaluation of the capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed. The goal of this supervisory assessment was to ensure that the equity capital held by these firms was sufficient in both quantity and quality to allow those institutions to withstand a worse-than-expected macroeconomic environment over the subsequent two years and yet remain healthy and capable of lending to creditworthy borrowers. This exercise, unprecedented in scale and scope, was led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC. Importantly, the agencies’ report made public considerable information on the projected losses and revenues of the 19 firms, allowing private analysts to judge for themselves the credibility of the exercise. Financial market participants responded favorably to the announcement of the results, and many of the tested banks were subsequently able to tap public capital markets.
Overall, the policy actions implemented in recent months have helped stabilize a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitization markets has picked up. Stock prices have partially recovered, and U.S. mortgage rates have declined markedly since last fall. Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be leveling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good. Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit. Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.