Credit Risk Measurement In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, Third Edition

CHAPTER 3

The Crisis and Regulatory Failure

INTRODUCTION

One fundamental lesson of the 2007-2009 crisis is that when financial institutions fail to perform their risk management functions, then financial markets and the real economy are adversely impacted. And when financial markets freeze, the government is left as the ultimate provider of liquidity and credit to the economy. In this chapter, we discuss the regulatory and governmental responses to ameliorate the crisis, as well as proposals for restructuring of the financial system so as to prevent the recurrence of similar crises in the future. International bank capital requirements, known as the Basel Accord, are described at length in Chapter 13.

CRISIS INTERVENTION

The U.S. Federal Reserve was extensively involved in seeking remedies for the economic crisis, augmenting its easy-money policy (put in place during the summer of 2007) with expansions in the safety net made available to nonbank financial institutions.¹ One of the key components of the Fed’s safety net is the lender of last resort privilege. This enables banks to meet their short-term, nonpermanent liquidity needs by borrowing directly from the central bank—at the discount window.

Historically, primary credit at the discount window in the United States was available to healthy banks for short periods up to a few weeks to meet temporary liquidity needs. Secondary credit was available to troubled banks, but only for a short period of time until the institution ...