Dallas Fed President Richard W. Fisher looks at the causes of the current financial troubles and examines the policies aimed at restoring the system to good working order.Financial crises ; Financial markets ; Securities ; Federal Reserve System ; Monetary policy

Richard W. Fisher

English

Research Papers in Economics

OnTheRecord
SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • NOVEMBER/DECEMBER 2008 8
Dallas Fed President Richard W. Fisher looks at the causes of the current financial 
troubles and examines the policies aimed at restoring the system to good working order.   
Working Our Way Through the Financial Crisis
A Conversation with Richard W. Fisher
sarily be the safest, or most stable, is that 
innovation and structural advancement yield 
additional byproducts besides stability. To il-
lustrate this point, let me refer to another 
banking phenomenon: diversification.
Suppose a bank’s ability to diversify its 
loan portfolio suddenly increases. How does 
it react? Does it simply enjoy its newfound 
stability?  Not  necessarily.  Experience  tells 
us that such a bank will typically increase 
its lending activity or hold less capital. As a 
result, financial stability, originally enhanced 
by  greater  diversification,  will  fall  back  to 
its previous level. What has changed is that 
more lending is possible, or less capital is 
required. Neither reduces risk.
Often,  the  most  innovative  and  ad-
vanced financial systems are also the bold-
est.  They  expand  more  aggressively  than 
their less advanced peers into new products 
and areas. As a result, they may also find 
themselves exposed to greater losses once 
global risk appetites decline.
Q. This particular financial episode seems 
unique. Is it?
A. After all that has happened since the sum-
mer of 2007, it seems fair to ask whether the 
so-called new financial system—despite its 
emphasis on securitization, structured credit 
products,  value-at-risk  statistical  modeling, 
credit derivatives and off-balance sheet ac-
tivity—is really all that new and different. 
In the end, commercial banks suffered 
losses because of errors in judgment. Some 
financial institutions attempted to reduce re-
quired capital and shield activity from regu-
lators’ view. Poor judgment compounded by 
capital arbitrage and accounting gimmickry 
has been the cause of innumerable financial 
crises throughout history.
Q. So, there is nothing fundamentally new or 
different this time?
A. One of the issues at the heart of this partic-
ular episode is the interconnected nature of 
financial market participants. Unfortunately, 
while everyone knows that interconnected-
ness is important, it is difficult to tell exactly 
how and to what extent things are woven 
together—sort of like the “butterfly effect.” 
willing to hold it. In retrospect, they com-
pounded risk to the financial system.
New and sophisticated statistical mod-
els, made possible in part by advances in 
computer technology, assured us that all this 
new risk was being properly and accurately 
measured. And the ratings agencies further 
comforted us by giving many of the new se-
curities their seal of approval—often, their 
highest triple-A seal.
I am firm in my view that financial mar-
kets remain prone to risk overshooting, and 
we  see  an  elevated  level  of  risk  aversion 
when the inevitable correction comes. That 
is what happened in the summer of 2007, 
when willingness to take on risk seemed to 
dry up overnight, leading to significant li-
quidity squeezes and funding pressures at 
banks and other creditors.
Q. At first, it seemed that the largest losses 
occurred in the U.S. Why was that?
A. Our country’s financial system is the most 
advanced in the world. One reason the most 
advanced financial system may not neces-
Q. What’s going on in the nation’s financial 
markets right now?
A.  The  financial  industry  is  facing  many 
headwinds. Even the more heavily regulated 
commercial banks and thrifts are now look-
ing at some major challenges. We are all well 
aware of how the bursting housing bubble 
impacted banks’ balance sheets and spilled 
over into what banks once regarded as off-
balance-sheet activities. 
Earnings suffer as writedowns continue, 
leaving some banks and other financial firms 
in dire need of capital. The FDIC’s list of 
problem banks continues to grow, and we 
are beginning to see a rise in bank failures, 
though to a lesser degree than many would 
have expected. 
The federal government now possesses 
a majority stake in one of the country’s larg-
est insurance firms, acts as conservator for 
two  of  the  biggest  players  in  the  nation’s 
mortgage  markets  and  is  actively  injecting 
capital into financial institutions across the 
country. An ancient Chinese curse condemns 
one to live in interesting times. I think we 
can all agree that a little boredom would be 
a welcome relief right now.
Q. So, what went wrong?
A. Most everyone agrees that risk appetites, 
fed  by  innovations  in  ways  to  measure, 
calibrate,  repackage  and  sell  risk,  became 
excessive during the boom years. These in-
novations—otherwise known as “securitiza-
tion” and the “originate-to-distribute” model 
of banking—are by no means new, but they 
certainly took on some new and uncharted 
dimensions in this decade. 
Structured  credit  products  became  all 
the rage and gave us an alphabet soup of 
new acronyms like ABS, CDS, CLO and CMO. 
These new instruments allowed financiers to 
slice and dice the risk associated with mort-
gages and other credits, presumably reduc-
ing risk by spreading it around to those most      FEDERAL RESERVE BANK OF DALLAS • NOVEMBER/DECEMBER 2008   SouthwestEconomy 9
“Our problems are not new. But they have been   
magnified by a certain type of hubris that   
viewed statistical modeling as infallible.”
setbacks,  remain  a  notch 
above  many  of  their  na-
tional peers.
Q. What about the Fed’s 
response? 
A. We have responded to 
the  current  crisis  in  both 
traditional and fairly inno-
vative ways. In addition to 
lowering the federal funds 
rate, the Fed has also intro-
duced several new facilities that represent a 
brand new approach to addressing liquidity 
problems. 
Our  term  auction  facility  was  intro-
duced in December 2007 as a market-ori-
ented mechanism that allows banks to bid 
for longer-term funds. In March 2008, we es-
tablished the term securities lending facility 
and primary dealer credit facility to further 
enhance liquidity for primary dealers and in-
vestment banks. 
In  September  and  October  2008,  we 
established backstops for commercial paper 
issuance  and  money  market  mutual  funds 
through  the  creation  of  the  asset-backed 
commercial  paper  money  market  mutual 
fund liquidity facility, the commercial paper 
funding facility and the money market in-
vestor funding facility. We entered into swap 
agreements with 14 other central banks to 
provide dollars in international lending mar-
kets. And, on Nov. 25, we began supporting 
the issuance of various consumer lending in-
struments with the introduction of the term 
asset-backed securities loan facility.
The expectation is that this innovative 
packaging  of  liquidity  support  and  back-
stops, combined with additional capital pro-
vided by the U.S. Treasury’s Troubled Asset 
Relief  Program,  or  TARP,  plus  regulatory 
oversight, should reinforce financial stability 
and set the stage for a recovery of the credit 
markets.
Q. Are these responses enough?  
A. In the near future, we will have to consid-
er more fundamental reform of our financial 
infrastructure. In addition to the usual calls 
for greater transparency and accountability, 
A butterfly’s wings disturb the air around it, 
setting off a chain of events that ends with 
a major storm in some remote part of the 
world. A small catalyst results in large—and 
sometimes catastrophic—consequences.
The crisis spreading through the global 
financial system can be thought of as a but-
terfly effect. Take credit default swaps, for 
example.  These  instruments  and  the  insti-
tutions they connect are quite complex. In 
principle,  though,  these  swaps  provide  a 
fairly simple service: Properly utilized, they 
are a form of insurance against the risk of 
the default of an underlying asset. 
While that might sound appealing, the 
value of the insurance is only as good as the 
person providing the guarantee. When that 
individual’s viability is called into question—
when  heightened  uncertainty  enters  the 
mix—the whole network will suffer the con-
sequences. It all comes down to what we say 
all the time—what is really common sense, 
but  is  nevertheless  often  ignored—“know 
your counterparty.” 
The  most  striking  and  truly  new  part 
of  the  recent  financial  cycle  was  the  mis-
take of replacing sound judgment with the 
mathematization of risk. An immense array 
of statistical gadgetry wielded by a new gen-
eration  of  quantitative  minds,  themselves 
emboldened  by  unprecedented  computer 
power, managed to squelch the wisdom of 
longtime bankers and seasoned financiers. 
Our problems are not new. But they have 
been magnified by a certain type of hubris 
that viewed statistical modeling as infallible.
Q. What sort of changes do you see for 
banking in the aftermath of our current 
difficulties?
A. I think we can expect to see a more back-
to-basics  approach  to  banking,  one  that 
relies  on  a  stable,  core  deposit  base  with 
ample capital. Here in Texas, we have wit-
nessed how such a basic approach can be 
quite profitable as a banking business mod-
el.  In  part  reflecting  our  strong  economy, 
Texas  banks  continue  to  outperform  their 
counterparts  across  the  country.  However 
you measure it—whether by return on as-
sets, noncurrent loans or charge-offs—Texas 
banks, while experiencing their own recent 
policymakers would do well to establish and 
follow several main principles of reform. 
For example, they should seek to avoid 
situations  that  privatize  profits  and  social-
ize losses. Institutions and investors that are 
free to make money in the financial system 
should also be free to lose it. That is the only 
way to maintain some degree of market dis-
cipline in the system. In addition, policymak-
ers should continue to stress the importance 
of capital adequacy at financial institutions. 
To be blunt, leverage got out of hand. It cer-
tainly is not an easy job, but supervision and 
regulation needs to make capital levels re-
flect the risks taken by an institution. 
Q. Will we be able to resolve our current 
difficulties?  
A.  If  financial  markets  are  prone  to  over-
shooting  and  undershooting,  we  may  find 
ourselves  wondering  what  we  have  to  be 
optimistic about. In the fearful and uncertain 
aftermath of bursting bubbles, we too soon 
forget the euphoric booms that fund our pur-
chases, expand our businesses and generally 
afford us the rich opportunities we enjoy in 
this country. 
We should always be mindful that this 
dynamic  system—or,  as  the  economist  Jo-
seph Schumpeter called it, this “creative gale 
of  destruction”—has  given  us  the  highest 
standard of living in recorded history. Some-
thing must be right about it.
But, make no mistake: We have been 
here before. Corrections from periods of ex-
cess are painful and disruptive. Our present 
difficulties may be trying, but they present us 
with a host of opportunities. I think we will 
use those opportunities wisely.

On the record: working our way through the financial crisis: a conversation with Richard W. Fisher

http://dallasfed.org/assets/documents/research/swe/2008/swe0806e.pdf

On the record: working our way through the financial crisis: a conversation with Richard W. Fisher

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