After the Supernova

• Author: Ashok Vir Bhatia
• Position: a Senior Economist in the IMF's Strategy, Policy, and Review Department, and was a member of the U.S. FSAP team.

The shock waves from the collapse of investment banking group Lehman Brothers were still reverberating around the world when, in early 2009, the U.S. authorities invited the International Monetary Fund (IMF) to conduct an assessment of the U.S. financial system.

The United States was in the midst of one of the most devastating and costly financial crises in a century, in terms of job and output losses, public debt, and damaging spillovers to the rest of the world.

The U.S. policy response had been bold and aggressive, helping to forestall a total systemic collapse. The U.S. authorities had provided extraordinary liquidity support to a wide swath of the financial system, and debate had begun on landmark legislative reforms to strengthen regulation and supervision. The timing of the IMF’s assessment represented an unusual challenge for both the IMF staff and the U.S. officials who participated, but also an important opportunity to learn from the crisis and help shape the reform agenda.

The IMF and World Bank had launched their joint Financial Sector Assessment Program (FSAP) in the wake of the Asian financial crisis of the late 1990s and, although more than 120 countries had already participated, this was the first time the United States was doing so.

To meet the challenge of assessing the world’s most complex financial system, the IMF assembled a large team led by its Monetary and Capital Markets Department. The team held more than 150 meetings between October 2009 and March 2010 involving U.S. congressional staff, essentially all U.S. federal financial regulatory bodies, several state regulators, and many private market participants. In June, the assessment was delivered to the U.S. authorities and was discussed in meetings between IMF Managing Director Dominique Strauss-Kahn, Chairman of the Board of Governors of the Federal Reserve System (Fed) Benjamin Bernanke, and Secretary of the Treasury Timothy Geithner. In July the FSAP’s findings were discussed by the IMF’s Executive Board, and its final reports were published.

Although the FSAP assessment covered a broad range of issues—stress tests of key financial institutions, a review of the quality of regulatory oversight against international standards, and an evaluation of arrangements for systemic liquidity and crisis management—this retrospective focuses on some of the major crisis events of 2008 and how they informed the team’s judgments on U.S. crisis management arrangements.

Casting a wider net

Much of the IMF’s policy advice on financial safety nets and resolution mechanisms, colored by hours of discussions with officials recounting their experiences and actions during the crisis, was shaped by one critical and recurring theme: U.S. officials repeatedly found themselves without appropriate legal powers to deal with failing or struggling nonbank financial firms such as Lehman Brothers and Bear Stearns.

The challenge, in short, was to extend crisis management tools for commercial banks to nonbanks, including holding companies of large, complex, financial groups with the potential to destabilize the system as a whole.

Bear Stearns provided the first warning that investment banking groups fully compliant with capital and liquidity regulations could nonetheless abruptly lose access to the short-term “repo” funding that was their lifeblood. Repo is a form of financing in which securities are sold for cash, often at a discount known as a “haircut,” under agreements to repurchase at a price differential amounting to interest, often the next day. On Thursday, March 13, 2008, haircuts charged to Bear Stearns on its repo borrowing jumped sharply, effectively rendering the group illiquid.

Until then, the secured nature of repo transactions had been thought to make such funding stable and reliable. With the benefit of hindsight, however, it became clear that even the repo market is vulnerable to sudden losses of confidence.

Events leading to the illiquidity of Bear Stearns raised the first questions about the U.S. central bank’s emergency lending tool kit. On Tuesday, March 11, 2008, the Fed had announced a program to increase...