A Terribly Risky Time: Capitalism itself could be at stake.

• Author: Connolly, Bernard

The transcript of the Federal Open Market Committee meeting in March 2006, Ben Bernanke's first as chairman, provides many examples of the Committee's arrogance, complacency, and hubris just twenty-four months before the collapse of Bear Stearns. That complacency did not extend to Dino Kos, then manager of the System Open Market Account. Kos warned that developments in the carry trade, notably in the Icelandic currency in circumstances of mounting concern about the stability of Iceland's banking system, were an indication that the search for yield "went to some pretty distant and unlikely places--as we are now discovering. It does raise questions about other sectors that leveraged money went into and about which we don't yet know." But, as the transcript records, the FOMC quite literally laughed off Kos's concerns. The Committee was laughing on the other side of its face not long after.

The report by Kos to the March 2006 FOMC meeting, on financial market developments, included something else that turned out to be particularly pregnant. The context was that of the banks' demand for central bank reserves (specifically, the Bank of New York's management of its required reserves), which had been pushing the fed funds rate above the top of the range set by the FOMC, requiring the provision of large additional amounts of reserves by the Fed. Kos commented prophetically that, "This episode illustrates the potential effect that just one bank with a large level of requirements can have on the entire funds market when it dramatically adjusts its reserve holdings in a very inelastic fashion." That remark was to have enormous resonance less than eighteen months later when fears about each other's solvency, initially occasioned by non-U.S. banks but rooted in U.S. developments, led to a dramatic freezing-up of the interbank market.

The remark also has resonance for the repo market turbulence of this autumn. The reasons for that turbulence are much disputed. But it is clear that banks' management of their reserves has been very inelastic, for whatever reason (Chairman and CEO Jamie Dimon has argued that postcrisis regulation has prevented JPMorgan, for one, from deploying its balance sheet elastically in the repo market in response to higher repo rates). But there is also a debate about whether the Fed's massive ongoing reverse-repo operations in response to those disturbances constitute a renewal of quantitative easing. In the 2006 episode, Bernanke...