The United States has made progress toward avoiding a new financial crisis, but has more yet to do to avert future financial instability, a Federal Reserve governor says.
In a little-noted speech given earlier this month at the Peterson Institute for International Economics, Daniel Tarullo, a specialist on banks and regulation, offered some encouraging words about progress made in the five years since the collapse of Bear Stearns destabilized the U.S. financial system.
That crisis began with the exposure of the risks of a shadow banking system, whose poorly regulated derivative products were previously seen to benefit the economy (by lowering financing costs, for example).
“When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based—notably, those tied to poorly underwritten subprime mortgages—a classic adverse feedback loop ensued,” he said, adding that investors became unwilling to lend across a broad range of assets.
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Compounding the problem, this credit freeze affected financial firms the government deemed too big to fail, thus triggering the bailout of firms such as Bear Stearns and AIG.
Unlike previous financial crises, these were “fast-moving episodes that risked turning liquidity problems into insolvency problems almost literally overnight.”
Fast-forward to today, and Tarullo, a former Clinton administration economic advisor, says that the largest institutions enjoy much greater protection against such episodes, mainly as a result of a doubling of capital reserves that decrease large institutions’ leverage.