IGTA Journal - Autumn 2017

those obligations, but kept open obligations in which the exposure went the other way, from them to Lehman. Not only did this create an imbalance in the risk exposures of the failed firm, but it also generated significant market churn and risk as firms scrambled to rebalance their own risk exposures. The contagion generated by the complex web of outstanding bilateral OTC derivative exposures significantly worsened the crisis and was responsible for much of the losses Lehman incurred in its bankruptcy . The near-collapse of the U.S. financial system underscores three critical lessons. First, financial institutions must be robust to stress. In particular, they need to have enough capital to be considered solvent even after sustaining significant losses, so that they can maintain the market access needed to recapitalize. They also need sufficient liquidity buffers so that they can respond to shocks without having to sell illiquid assets. The forced sale of illiquid assets can push asset valuations far below their fundamental value, which can increase insolvency risk. And, it is important that they not be overly reliant on short-term wholesale funding, which can evaporate during times of stress. Second, when we identify potential sources of instability that could amplify shocks, we need to make structural changes to the financial system to reduce or eliminate them. For example, the financial crisis made it clear that changes were needed in how tri-party repo transactions were unwound each day, net asset values were calculated for prime money market mutual funds, and OTC derivative obligations were cleared, settled, and risk-managed. Third, there should be a viable and predictable resolution regime. We need to be able to resolve a large, systemically important bank or securities firm in a way that limits contagion and stress on the rest of the financial system, while at the same time protecting the taxpayer against loss. Meanwhile, central counterparties (CCPs)—through which most standardized OTC derivatives must now be cleared—need to be open for business for the financial system to operate effectively. Here, the emphasis should be on ensuring that these financial market utilities can open for business the day after the failure of one or more of their participants. Credible resolution regimes for large banks and securities firms—and credible recovery regimes for CCPs and other critical financial market utilities—should help support confidence during times of stress. These measures would make the financial system less prone to booms and busts. Financial intermediaries would be more robust to stress when busts inevitably occur, and contagion to the broader system would be reduced when a systemically important firm fails. Such changes should reduce the likelihood of the failure of a large, systemically important firm and the negative consequences of such a failure on the broader financial system. These steps should help to ensure that credit flows can be sustained throughout the business cycle. Considerable progress So, where are we relative to what is needed? As I see it, there has been considerable progress. The nation’s largest banks are much safer as a result of substantially higher capital and liquidity requirements, as well as robust stress tests. This enhanced resiliency has been achieved without a significant negative impact on the broad availability of credit—recognizing that it is now more difficult for households with low credit scores to obtain a mortgage. Most importantly, improving the capacity of such firms to continue to lend during times of stress should make the overall economy more stable. We have also made significant progress in addressing many of the structural weaknesses uncovered by the financial crisis. Money market reform has made the prime money market mutual fund industry smaller and safer. The elimination of the net asset value convention for institutional prime money market mutual funds has made these funds smaller and less prone to runs during times of crisis . The tri-party repo system has been made more stable as intraday 2 3 4 4 / 7 BIS central bankers' speeches IGTA eJournal | Autumn 2017 | 56