Journal of Economic Literature 2015, 53(4), 975–995 http://dx.doi.org/10.1257/jel.53.4.975

Stress for Success: A Review of Timothy Geithner’s Financial Crisis Memoir †

Gary Gorton*

Timothy Geithner’s memoir of the financial crisis of 2007–08—Stress Test: Reflections on Financial Crises—is an important historical document offering details of how policies were formed and implemented during the crisis, showing the political constraints, and offering lessons for future crises. Walter Bagehot’s classic rule for fighting crises— that the should lend against good collateral at a high rate—is passive and incomplete. Geithner argues for the use of overwhelming force to reestablish confidence. Also, although the ’s new crisis lending programs needed to be anonymous so as not to reveal weak banks’ identities—“stigma”—the stress tests during the crisis did reveal information that may have been useful in reestablishing confidence. ( JEL B31, E44, E63, G01, G21, G28)

1. Introduction (i.e., the costs to banks from having their identity revealed at emergency lending pro- imothy Geithner’s memoir of the grams), navigating through the politics, the TFinancial Crisis of 2007–08, Stress Test: failure of , dealing with the Reflections on Financial Crises, is a valuable policy naysayers, and timing the use of over- historical record of the formation and imple- whelming force. During the crisis, a new tool mentation of the policy responses during the was introduced to reestablish confidence, crisis. Lessons for future crises can be dis- the stress tests of large banks. tilled from his recollections. Geithner’s crisis Events during the crisis were chaotic and response was informed by his direct experi- fast moving. Fundamentally, policymakers ences of the Mexican and Asian crises. In the did not know initially what was actually hap- book, he discusses conducting triage during pening, but had to respond, at first in reaction the crisis, the importance of avoiding stigma to events as they unfolded and then, with the Troubled Asset Relief Program and the stress tests, proactively. Timothy Geithner, like * Yale and NBER. Thanks to Michael Bordo, Lori , was there during the entire Gorton, Bengt Holmström, , Guillermo Ordoñez, and David Warsh for comments. Gorton con- crisis period, first as president of the Federal sulted at AIG Financial Products during 1996–2008, and Reserve Bank of (and coinciden- has consulting relationships with Starr Inc. and Barclays tally, vice chairman of the FOMC) and then Bank. † Go to http://dx.doi.org/10.1257/jel.53.4.975 to visit the as US treasury secretary. “Our response to article page and view author disclosure statement(s). the global financial crisis is still wrapped in

975 976 Journal of Economic Literature, Vol. LIII (December 2015) myth and haze and misperception. And I was is ­important; it cannot come too early, as that in the middle of it from start to finish . . .” may signal that the situation is worse than (p. 12).1 “We lived through months of terror” the market thinks. And it cannot come so late (p. 19). His book is a record of this. as to be ineffective. It was largely Geithner Pretty much from the beginning, who had to get the timing right. Bernanke and Geithner spoke of the cri- Economics enters the memoir only with sis as a bank run. Then FOMC Governor reference to “,” Bagehot’s Kevin Warsh (2009) noted the chaos in April rule, and Kindleberger’s 1996 book Manias, 2009: “Characterizing the current period as Panics and Crashes, which is mentioned in a ‘recession’ is still wanting, insufficient in passing. And that is a telling point for econ- some important respects. In my view, this omists. Economists had little to offer in period should equally be considered a panic the way of policy advice during the crisis. . . . ,” likening it to the Panics of 1837, 1857, Kindleberger’s vague description of a cycle 1873, 1893, and 1907. But, a public narra- of manias, followed by panics, and ending in tive of the underlying causes of the crisis crashes seems to be a kind of reference point was not articulated until Bernanke (2009a, since macroeconomic models cannot display August), who explained the events as “ . . . crises. But Kindleberger does not explain a generalized run by providers of short-term financial crises and his description does not funding to a set of financial institutions, pos- lead to any policy advice. Economics (actu- sibly resulting in the failure of one or more of ally insurance) contributed the concept of those institutions.” “moral hazard.” Geithner’s point about moral Geithner emphasizes, and it is one of the hazard is that during a crisis, any policy to main points of the book, that what is needed ameliorate the situation is open to the charge to combat a financial crisis is the “. . . use of “moral hazard,” but a crisis is not the time of overwhelming force to quell panics . . .” to address that issue. Moral hazard is per- (p. 397). “Overwhelming force” refers to haps controversial, but the first point—that having a credibly large amount of commit- we need models of crises—should not be. ted resources available to use with discretion During the crisis, there seems to have during a financial crisis. Geithner learned been a steady stream of criticism from this in the previous crises he experienced “moral hazard fundamentalists.” “. . . I found as a policymaker; the Mexican crisis and the more hawkish obsessions with moral the Asian crisis. However, obtaining and hazard and inflation during a credit crunch using overwhelming force is complicated bizarre and frustrating” (p. 131). And after by politics. “It turned out that things had Lehman: “I had heard enough moral haz- to get a lot worse before Congress would ard fundamentalism” (p. 217). Geithner even consider expanding our authority to becomes quite irritated at constantly being make things better, a common problem in told that crisis response policies would crisis response” (p. 164). “It took the fall of cause “moral hazard.” In fact, the term Lehman and the impending collapse of AIG “moral hazard fundamentalists” appears to to persuade President Bush and [Treasury have become part of the policymakers’ lex- Secretary] Hank [Paulson] to seek legislative icon during the crisis. Before he joined the authority to try to repair the entire system” Obama administration Larry Summers wrote (p. 208). The timing of overwhelming force an op ed in the Financial Times, September 23, 2007, entitled “Beware Moral Hazard 1 All unattributed quotations and pages numbers refer Fundamentalists,” arguing that in a financial to Geithner’s book. crisis “avoiding moral hazard” cannot be the Gorton: Stress for Success 977 basis for crisis response policies.2 Geithner costs to rise or maybe generating a bank run.5 also has this view. Stigma issues arise throughout the book. Lehman Brothers filed for bankruptcy on And although never mentioned by Bagehot, September 15, 2008, and within a month maintaining the secrecy of borrower identi- Congress passed the Troubled Asset Relief ties seems paramount during crises. Program (TARP). TARP was $700 billion During the crisis of 2007–08, the new allocated by Congress to address the crisis; Federal Reserve lending programs that it passed on October 3, 2008. Bernanke and were introduced were carefully designed to Geithner argue that they could not legally avoid stigma.6 The identities of borrowers have saved Lehman Brothers. Clearly, the were kept secret. But, the stress tests intro- results of the Lehman bankruptcy were dev- duced during the crisis had exactly the oppo- astating. Lingering still is the question of site goal: find and publicly reveal the weak whether large banks should be allowed to fail banks! The stress tests of the largest banks during a crisis. Was Lehman’s bankruptcy a are widely viewed as a great success. The mistake? A large part of the book is devoted banks calculated losses that they would incur to the events surrounding Lehman Brothers. during a forward-looking stress scenario Bagehot’s (1873) rule that in a crisis the proposed by the government. The banks’ central bank should lend freely, at a high rate, results (in terms of bank capital) were then and on good collateral is frustratingly vague.3 compared to the regulators’ calculations and In a crisis, events are not clear. In particular, then the results were announced in terms of it is not even clear if there is a crisis. During how much capital each bank would have to a crisis it is not exactly clear what consti- raise. Yet, there were no runs on the banks tutes “good collateral.”4 Bagehot’s advice is identified publicly as weak. The stress tests a passive and incomplete response to a cri- came late in the crisis and the results may sis. Most likely because it does not have the have eliminated any residual uncertainty. all the right tools, the central bank is, in a The information environment during a crisis way, passive because it relies on banks com- deserves careful study. ing forward to borrow. Use of the discount Broadly, policy responses in a crisis are window faces the problem of “stigma,” which fundamentally about managing expectations. refers to a bank’s reluctance to go to the dis- The lenders, who ran on the banks demand- count window because of fears that depos- ing cash, need to be convinced that it is safe itors, creditors, and investors will view this to lend again. That is, at one point in time, as a sign of weakness, causing its borrowing there is a panic, and later, beliefs are revised and the runs dissipate. Why do beliefs change? Geithner proposes that overwhelm- 2 See http://www.ft.com/intl/cms/s/0/5ffd2606-69e8- ing force is the key to regaining confidence. 11dc-a571-0000779fd2ac.html#axzz37dlPrATn. Overwhelming force requires backing pol- 3 Ben Bernanke reported that the Federal Reserve fol- icies with a sufficiently large amount of lowed Bagehot’s rule (see Bernanke 2014a and 2014b). Also, see King (2010) with regard to the Bank of England money. This war chest must be perceived and Draghi (2013) with regard to the European Central as sufficient. It is hard to know how much Bank. 4 Bagehot famously quotes one of the Bank of England’s more senior directors, Mr. Harman, that, during the Panic of 1825, the Bank of England “lent by every possible means 5 Stigma was not a problem in England in the nine- and modes we have never adopted before . . .” (Lombard teenth century because of the industrial organization of Street, p. 51–2). Also see Flandreau and Ugolini (2011) on banking. This is discussed further below. the collateral the Bank of England took during the Panic 6 In particular, they were auctions in which many banks of 1866. bid at the same time. 978 Journal of Economic Literature, Vol. LIII (December 2015) will be sufficient. “Larry [Summers] and I In my ­personal experience, I would date the told the President we might have to ask for start as August 9, 2007, when repo haircuts another TARP, at a time when Congress had started to increase. Formal dating of the zero interest in more bailouts” (p. 5). In a cri- events in the crisis, based on Bai (2010), sis it not clear, almost by definition, how to is provided by Gorton, Metrick, and Xie determine the size of the war chest. Another (2014). example is the head of the European Central What was going on? By October 2007, Bank (ECB), Mario Draghi’s statement that events were described as a bank run. the ECB was “. . . ready to do whatever it Bernanke (FOMC Minutes, October 28–29, takes to preserve the Euro.”7 Although the 2008): “I think there was a panic brought formation of expectations is at the center of about by the underlying concerns about macroeconomics, in the context of financial the solvency of our financial institutions. crises, it has not been studied. That panic essentially turned into a run. In what follows, I discuss the above issues Companies like that had adequate in terms of Geithner’s experiences, and Basel capital faced a run on their deposits, sometimes in a broader context. In sec- which was self-fulfilling. The investment tion 2, I look at the unfolding of the crisis banks essentially faced runs.” (p. 149). The and discuss the meaning of “financial crisis.” Fed announced the introduction of a new In section 3, I look at the policy responses. lending facility, the Term Auction Facility Managing expectations and overwhelming (TAF), on December 12, 2007. Unlike the force are the subjects of section 4. Lehman discount window, where borrowers’ iden- is discussed in section 5. Section 6 concerns tities leaked and they were then identified moral hazard. And the stress tests are exam- as weak, TAF was designed to avoid this ined in section 7. Section 8 offers some tenta- by using auctions. So, Douglas Diamond’s tive conclusions and outlines open questions (2008) point that: “Financial crises are for economics. everywhere and always due to problems of short-term­ debt” was again confirmed. Only the form of the debt and the form of 2. The Crisis the banks had changed. Instead of demand What is a “crisis”? When are events a deposits, the debt was both sale and repur- “crisis”? “At the start of any crisis, there’s chase agreements (repo) and asset-backed an inevitable fog of diagnosis” (p. 119). commercial paper (ABCP), and the “banks” Is it the start of a recession or something were dealer banks. more extreme? 8 When should the central But, it seems that the Federal Reserve (and bank act? On August 10, 2007, the Federal most everyone) did not grasp the significance Reserve issued a press release saying it of what was going on until Lehman failed a would provide reserves as necessary due little less than a year later. For example: to the “unusual funding needs because of 9 Economic growth in late 2007 and during 2008 ­dislocations in money and credit markets.” was likely to be somewhat more sluggish than participants had indicated in their October projections. Still, looking further ahead, par- 7 http://www.ecb.europa.eu/press/key/date/2012/html/ ticipants continued to expect that, aided by sp120726.en.html. an easing in the stance of , 8 The determination of whether an event is a crisis and when it starts and ends is a problem for researchers more economic growth would gradually recover as generally. See Boyd, De Nicolò and Loukoianova (2011). weakness in the housing sector abated and 9 http://www.federalreserve.gov/newsevents/press/ financial conditions improved, allowing the monetary/20070810a.htm. economy to expand at about its trend rate Gorton: Stress for Success 979

in 2009. Federal Open Market Committee show that the Great Depression, the reces- Minutes, December 11, 2007.10 sion of 1937, and the recent financial crisis stand out in the data as very distinct. This was a widely-held view and it is worth Bank runs are about cash; banks must pondering why this was the case. The paper pay out cash to lenders who do not want to I delivered at the August 2008 Federal roll their debt. But then the banks have to Reserve Bank of Kansas City’s annual Jackson sell assets to raise cash, pushing asset prices Hole Conference was entitled “The Panic down. Indeed, the prices of all assets go of 2007.” To me, it was clear by then that down, in particular the best assets, since they events were systemic. Gorton, Metrick, and are sold under the view that they can raise Xie (2014) show empirically that systemic the most cash. So, the crisis spreads to these fragility was building up in the period prior other assets, e.g., AAA/Aaa credit card, auto to Lehman. Why did it take the Fed and the loan, and student loan asset-backed securi- Treasury so long to see this? One possibil- ties. Geithner (2008a): ity is that they do not trade in the relevant financial markets, where trading would allow What we were observing in the U.S. and global them to see what was happening. That was financial markets was similar to the classic pat- tern in financial crises. Asset price declines— probably part of it. But “seeing” is a func- triggered by concern about the outlook for tion of your paradigm. Using textual analy- economic performance—led to a reduction in sis of the FOMC minutes of 2007, Fligstein, the willingness to bear risk and to margin calls. Brundage, and Schultz (2014) argue that the Borrowers needed to sell assets to meet the inability to see the unfolding financial crisis calls; some highly leveraged firms were unable to meet their obligations and their counter- as a systemic event prior to Lehman was due parties responded by liquidating the collat- to their common macroeconomic paradigm. eral they held. This put downward pressure Perhaps so. on asset prices and increased price volatility. A crisis is a systemic event. “Of the twen- Dealers raised margins further to compensate ty-five largest financial institutions at the start for heightened volatility and reduced liquidity. This, in turn, put more pressure on other lev- of 2008, thirteen failed (Lehman, WaMu), eraged investors. A self-reinforcing downward received government help to avoid failure spiral of higher haircuts forced sales, lower (Fannie, Freddie, AIG, Citi, BofA), merged prices, higher volatility and still lower prices. to avoid failure (Countryside, Bear, Merrill, Wachovia), or transformed their business What do “market prices” mean in this structure to avoid failure (, context? “If a security sold at its $100 ‘par’ Goldman)” (p. 255–6). Bernanke made the value a month ago, and you couldn’t sell it for same point. The FCIC Report (2011) quotes $30 today, but it might be worth $89 in five Ben Bernanke’s testimony that during years, what was its true value? And what kind September and October 2008 “. . . out of 13 of write-down should you take?” (p. 140). of the most important financial institutions in Consequently: “In a financial crisis, insol- the United States, 12 were at risk of failure vency can be in the eye of the beholder. If within a period of a week or two” (p. 354). AIG had been forced to mark all its assets to Recent research showing that crises are very their depressed market prices during a selling different from recessions is due to Atkeson, frenzy, then sure, it would have been insol- Eisfeldt, and Olivier-Weill (2014). They vent. Just about every financial firm would’ve been insolvent” (p. 206). Markets effectively 10 http://www.federalreserve.gov/monetarypolicy/ shut down for a range of ­asset-backed securi- fomcminutes20071211.htm. ties, and interbank ­markets shut down, where 980 Journal of Economic Literature, Vol. LIII (December 2015)

“shut down” means that trading was so thin the government. In the period prior to the that the prices were basically meaningless. It Federal Reserve’s existence, during a crisis, must also be kept in mind that the markets banks would suspend convertibility, simply being discussed are over-the-counter mar- refusing to give cash to depositors, and in kets, so prices are not readily observable in the Great Depression, President Franklin any case.11 Delano Roosevelt declared the banking hol- The issue Geithner raises is an important iday. There simply were no markets to sell one. The predominant view is that securi- bank loans. That was the point of suspension. ties markets are always the best guide to Without suspension or government interven- fair value, no matter what. This is the view tion, asset prices will plummet because even based on the price efficiency of stock mar- as prices become lower and lower, there are kets. And, this is the view that informs the not enough willing private buyers. Only the Financial Accounting Standards Board Fed and the Treasury can buy trillions of dol- (FASB), although the FASB agreed to let lars of assets in a short period of time. That banks use more discretionary judgment and is one way to think of a financial crisis. In the the accountants towards the end of the cri- crisis of 2007– 08, there was no mechanism sis.12 The argument that assets should be to avoid selling assets. Assets had to be sold, marked-to-market even during a crisis is that depressing prices. Then, mark-to-market otherwise banks would be able to hide losses. accounting can spread the crisis.13 This view does not admit the possibility of a But, calling the events a “bank run” does crisis. The markets in question are not stock not really explain what happened. What markets, but over-the-counter debt mar- exactly is a “banking panic”? This is a very kets. These are not price discovery markets. important question for thinking about pol- Rather, the whole point of these markets is icies to prevent bank runs. A related ques- that there is no price to discover in noncrisis tion is: Why are banks regulated? Dang et times (see Holmström 2014). al. (2014) argue that banks are optimally In a crisis, there is a fear of adverse selec- opaque, so that their short-term debt can tion, a fear that counterparties are engag- be used in transactions where the debt ing in private price discovery. Fearing this, is accepted at par. Dang, Gorton, and there is a run on the banks, which in turn Holmström (DGH) (2013) argue that the sell assets to raise cash. Since all the banks optimal contract for transactions is debt sell assets, the prices of their assets plum- backed by debt. Indeed, banks select their met. But, in a bank run, no one wants the assets so that it is very expensive to produce banks’ assets for fear of adverse selection. information about the payoffs of these assets, That is, in a systemic financial crisis there e.g., loans to small businesses and consumer are no private agents capable of buying loans. Opacity is optimal and that is why the assets of the banking system, except banks are regulated. Before the financial crisis, both sale and repurchase agreements (repo) and asset-backed commercial paper 11 There usually is no reason to observe the prices of were often backed by asset-backed securities money market instruments. Holmström (2014) distin- guishes between price discovery markets—equities—and money markets, where the point is to avoid the need for any price discovery. 12 E.g., PriceWaterhouseCoopers (2008): “Although it 13 Laux and Leuz (2010) find no evidence that has generated controversy, fair value continues to repre- ­mark-to-market accounting exacerbated the crisis, but they sent the best available methodology for determining and studied US commercial banks, not the investment banks reporting the value of financial instruments” (p. 2). that were at the core of the crisis. Gorton: Stress for Success 981

(ABS) (including residential and commercial Pauzner (2005). Still, many, many, questions mortgage-backed securities). remain about how panics work. Short-term debt is an optimal security for trading and storing value because debt is 3. The Policy Responses to the Crisis: information insensitive, that is, it is common Dealing with Stigma knowledge that no agent has an incentive to privately produce information about the There is not much guidance for policy payoffs of the debt. The debt is free from responses during a financial crisis. Bagehot adverse selection. Information insensitivity (1873) distilled his rule for fighting crises equals liquidity. A bank run or panic is an from observing events in England in the information event.14 Gorton (1988) showed mid-nineteenth century (see Bordo 1990 and empirically that during the National Banking Bignon, Flandreau, and Ugolini 2012).16 In Era, 1863–1914, when unexpected news of fact, things are more complicated. Bagehot’s a future recession arrived (in the form of an (1873) rule does not correspond to what innovation in a leading indicator of reces- we observe in crises. He omits an essential sions), depositors at banks ran to withdraw element: secrecy (see Gorton and Ordoñez their money. A crisis is a situation where con- 2014b). The organization of the English ditional on a public shock—e.g., house prices banking system essentially ensured the are declining—the debt becomes informa- anonymity of emergency borrowers.17 And tion sensitive, so adverse selection or the fear Flandreau and Ugolini (2011) argue that of adverse selection. The debt is then illiq- Bank of England did not even want to know uid. Market “prices” are meaningless. the identities of borrowers: “An important Short-term debt backed by asset-backed feature of the picture that emerges from this securities (ABS) works until lenders doubt literature is the notion that, paramount in the the value of the ABS.15 Kevin Warsh (2008), transformation of the Bank of England into at the time an FOMC governor, diagnosed a modern central bank, was the development the underlying problem in the crisis as being of ‘anonymous’ dealing with the market.” So, related to “the explosive growth in securiti- for Bagehot the issue never came up. zation markets in recent years. The loss in While in noncrisis times central banks confidence in structured products was first have trended towards increasing transpar- evidenced last year in securities backed by ency, during crises information is suppressed. subprime mortgages. . . . Participants also lost Even in the period prior to the Federal confidence in the value provided through the Reserve’s existence in the United States, securitization process itself.” Geithner also information was suppressed by private bank describes the events as a panic. Recognition clearinghouses during periods of suspension of the crisis as a panic, a distinct event from of convertibility (see Gorton and Tallman a recession, is one important lesson to take 2014). The suppression of information refers from the book. to the identities of banks making use of the But, how exactly does the panic start? central bank’s (or clearinghouses’) discount Morris and Shin (2012) argue that even small amounts of adverse selection can result in a 16 There is a very large literature on Bagehot and the loss of confidence. Also, see Goldstein and lender-of last-resort. See, e.g., Goodhart (1988, 1995), Freixas et al. (1999, 2000). 17 Capie (2007) explains that in England, geographically 14 Also, see Gorton and Ordoñez (2014a). between the country banks and the Bank of England, was a 15 On asset-backed securities, see Gorton and Metrick ring of discount houses. This kept the identity of distressed (2013). country bank borrowers secret. Also, see Capie (2002). 982 Journal of Economic Literature, Vol. LIII (December 2015) window or other special lending facilities. Bloomberg L.P., the news organization, Similarly, in the pre-Fed period, information submitted requests under the Freedom of about bank balance sheets that was required Information Act to the Board of Governors to be published in normal times was sup- of the Federal Reserve System in April and pressed during suspension periods, as were May, 2009, requesting information about the identities of banks borrowing from the loans made under the special lending pro- clearinghouse’s internal discount window. grams, including specifically the identities of Throughout Geithner’s book, this issue of borrowers. The Board of Governors of the stigma arises (although, curiously, it is not in Federal Reserve refused the requests and the index). Use of the central bank’s discount Bloomberg sued (Bloomberg L.P. v. Board window faces the problem of “stigma,” which of Governors of the Federal Reserve System, refers to a bank’s reluctance to go to the dis- 601 F.3d 143 2d Cir. 2010). See Biscontini count window because of fears that depos- (2011) and Berry (2012). The defense against itors, creditors, and investors will view this this suit was the argument that stigma would as a sign of weakness, causing its borrowing create problems if the borrowers’ identities costs to rise or maybe generating a bank run. were revealed. Brian Madigan (2009), at “Stigma was a real danger . . .” (p. 235). In the time Director of the Board’s Division response to stigma, the central bank created of Monetary Affairs: “This stigma . . . can new anonymous lending programs during the quickly place an institution in a weakened financial crisis, the Term Securities Lending condition vis-à-vis its competitors by causing Facility, the Primary Dealers Credit Facility, a loss of public confidence in the institution, and others, in addition to TAF.18 All these a sudden outflow of deposits (a ‘run’), a loss programs were designed to use auctions to of confidence by market analysts, a drop in make loans in secret, not publicly revealing the institution’s stock price, and a withdrawal borrowers’ identities. Bernanke (2010b): of market sources of liquidity. In extreme “. . . [because of] the competitive format cases, such developments can lead to clo- of the auctions, the TAF [Term Auction sure of the institution” (p. 10). If information Facility] has not suffered the stigma of the leaks out, there will be runs. The UK parlia- conventional discount window” (p. 2).19 ment attributed the run on Northern Rock Armantier et al. (forthcoming) found that: to a leak by BBC that the bank had asked “. . . banks were willing to pay a premium for and received emergency loans from the in excess of 44 basis points on average (143 Bank of England.21 basis points after the bankruptcy of Lehman For these reasons, the response of central Brothers) to avoid borrowing from the dis- banks and private bank clearinghouses, his- count window. Discount window stigma is torically, to financial crises has been to try economically relevant as it increased banks’ to prevent information from being revealed. borrowing costs by up to 32.5 percent of If bank-specific information leaks out, then their net income during the crisis.”20 the financial system might unravel sequen- tially as the weakest bank is run on, and then the next weakest, and so on. In the United 18 Lending programs were also created by the European States, as events unfolded, this was the fear: Central Bank. See Stolz and Wedow (2010). 19 It is not obvious how an auction avoids stigma. “Merrill’s stock had lost more than a third Perhaps it is a coordination device. This is an area for of its value in a week. If Lehman went the future research. Also see Stolz and Wedow (2010) on pro- grams in the . 20 Also, see Ennis and Weinberg (2010) and Furfine 21 See http://www.publications.parliament.uk/pa/ (2003) on stigma costs. cm200708/cmselect/cmtreasy/56/5602.htm. Gorton: Stress for Success 983 way of Bear, Merrill was widely understood Nimalendran (2013) find some evidence that to be the next-weakest investment bank, the spreads on bank stocks rose during the finan- next obvious target for a run” (p. 181); “ . . . cial crisis.24 This question remains open. everyone on Wall Street knew that if Morgan Why, during a crisis, is it important to sup- [Stanley] went the way of Lehman, Goldman press bank-specific information? To keep would be next” (p. 204). information from being revealed in markets, What is the point of designing anonymous opacity must be recreated by essentially lending programs if bank-specific informa- backing the financial system with the gov- tion is revealed via the banks’ stock prices? ernment, either implicitly or explicitly. Then The Securities and Exchange Commission the issue becomes whether the government (SEC) also acted to suppress bank-specific is solvent. “To resolve a crisis, a government information, revealing the weak financial has to show the capacity and the will to end institutions, by instituting short-sale bans it; it has to demonstrate through its deeds on almost 800 financial firms starting on that its words can be trusted. Credit and September 18, 2008.22 Geithner: “. . . the credibility share the same Latin root. It was SEC temporarily banned the short selling of bad enough when Russian and Indonesian 799 financial stocks, a heavy-handed effort to politicians broke promises. We were the stop the stampede of speculation and rumor United States” (p. 223; emphasis in original). mongering. . . . The ban’s most immediate This becomes the basis for the use of over- beneficiary appeared to be Morgan Stanley; whelming force. CEO John Mack was publicly accusing the shorts of sabotaging his firm” (p. 203). If the 4. Overwhelming Force and Managing short sale bans prevented adverse selection, Expectations uninformed buyers would be more willing to trade. Appel and Fohlin (2010) argue that How can the government respond in a crisis the bans on covered short sales improved (aside from introducing special lending pro- market liquidity. Beber and Pagano (2013) grams)? Based on his previous experiences find the opposite.23 Flannery, Kwan, and with crises, Geithner thinks that panics need to be fought with “overwhelming force,” not piecemeal—the “Vietnam approach.”25 In 22 See SEC Release 34-58592 (http://www.sec.gov/ discussing the Korean experience during rules/other/2008/34-58592.pdf). Similar bans were put in the Asian Crisis, he noted that “. . . what we place in England and in many European and other devel- oped market regulators temporarily banned the short sell- thought was overwhelming force didn’t stop ing of the stock of financial firms after September 2008. the run. The markets weren’t sure the com- Also, on May 19, 2010, the German Federal Financial mitment was credible. . .” (p. 61). And about Supervisory Authority (BaFin) prohibited naked short sales of euro-denominated government bonds, naked : “We hoped to put a lot of ‘money credit default swaps (CDSs) based on those bonds, and in the window,’ enough to look big compared also naked short sales of the stock of Germany’s ten largest financial institutions. “Naked” short selling means selling a security when the seller has not borrowed the security. See Gruenewald, Wagner, and Weber (2010) for a list of world- wide short-selling bans that were instituted during the 24 There are quite a few other papers on this topic, e.g., financial crisis. In Europe, naked CDS on sovereign debt Boehmer, Jones, and Zhang (2013) and Autore, Billingsley, was also banned (EU Short Selling Regulation (236/2012). and Kovacs (2011). 23 What about CDSs? Did they reveal information 25 “Overwhelming force” is the essence of the Powell during the crisis? Here the evidence is not clear-cut. Doctrine. Following Vietnam, Colin Powell developed the Mitchell and Pulvino (2012) show evidence that during the “Powell Doctrine,” part of which was that if a military force financial crisis the “arbitrage” relationship between bond is to be used, it should be done so with “overwhelming yield spreads and broke down. force.” 984 Journal of Economic Literature, Vol. LIII (December 2015) to the liabilities that could run” (p. 55).26 weaknesses of the nine, all were told that Treasury Secretary William McAdoo also they had to take TARP money. “I warned the used overwhelming force in managing the bankers that if they all didn’t accept the cap- crisis of 1914, the last successful example ital, TARP would become stigmatized . . .” of crisis management in the United States. (p. 238). Silber (2007): “McAdoo succeeded in August “Overwhelming force” is about expecta- 1914 because he did not hesitate to bludgeon tions in the context of an information envi- the crisis with a sledgehammer” (p. 6).27 So, ronment that has focused attention on the this message is not new, but Geithner redis- financial system because bank-specific infor- covered it. mation is not present, as a matter of policy. Overwhelming force was not possible ini- Geithner’s view is that in order to create tially during the 2007–08 crisis because there positive expectations that the banking sys- were many problems. “We only had limited tem will survive, it must be demonstrated tools to defend against a run on firms outside that the war chest available to lend to banks the commercial banking system, at a time is large enough. But how big does the war when running seemed increasingly rational” chest need to be? This is not clear. And there (p. 173). “Our inconsistency had multiple is no way to know in advance. causes; the limits of our authority, which made There are different types of “overwhelm- us look like we were flailing; the balkanization ing force,” but the crisis response must be of our authority, which put different tools in credible, and ultimately that means a large the hands of different officials with different war chest—“money in the window.” Laevan strategies and different perceived responsi- and Valencia (2008, 2010, 2012) study sys- bilities; and the inevitable messiness of fight- temic crises around the world since 1970 ing a crisis with limited time and incomplete and show the instances where various over- information to make decisions. But whatever whelming force-type policies were used, the cause, our unpredictability undermined including deposit freezes, bank holidays, the effectiveness of our response” (p. 224). asset purchases, blanket guarantees of bank However, once Lehman failed the situation debt, or bank nationalizations. These poli- was different. cies are essentially forms of liquidity support. The source of overwhelming force was And, their success or failure is related to the to be the Troubled Asset Relief Program credibility of the resources backing the policy. (TARP), part of the Emergency Economic Another important example of manag- Stabilization Act of 2008, authorizing ing expectations occurred during the Great $700 billion of expenditures. The hope was Depression when Roosevelt took office in that TARP would be the ­overwhelming March, 1933. When Roosevelt took office, force. The first step under TARP was to the country was in the midst of nationwide inject $125 billion into the nine largest finan- bank runs. The President declared a national cial institutions that held roughly two-thirds banking holiday on March 5, 1933. Then, on of the assets in banking system. In order to March 12, 1933, Roosevelt gave the first radio avoid revealing the relative strengths and address to the nation by a US President. It was about fifteen minutes long.28 The next day, 26 A recent example, of what “in the window” means: http://www.forbes.com/sites/gordonchang/2014/03/30/ -officials-fibbed-to-depositors-to-stop-bank-runs/. 28 The speech can be heard on YouTube: http://www. 27 McAdoo also undertook extraordinary measures, like .com/watch?v=z9CBpbuV3ok and the text is here: closing the New York Stock Exchange for four and half http://millercenter.org/president/fdroosevelt/speeches/ months. speech-3298. Gorton: Stress for Success 985 when the banks reopened, depositors lined Commission (FCIC) (2009) interview: up to redeposit their money (see Smith 2007 “ . . . I will maintain to my deathbed, that we and Silber 2009). The speech was remarkable, made every effort to save Lehman, but we in particular, for explaining the crisis as a bank were just unable to do so because of a lack run. What changed depositors’ beliefs? Silber of legal authority. . . . In the case of Lehman (2009) argues that the Emergency Banking Brothers, there was just a huge hole. I mean, Act of 1933, passed by Congress on March they were insolvent and they had a thirty- to 9—combined with the Federal Reserve’s forty-billion-dollar hole in their capital struc- commitment to supply unlimited amounts ture” (p. 29, FCIC Interview). Geithner also of currency to reopened banks—created de argued that “. . . without a willing buyer, we facto 100 percent deposit insurance. The didn’t think we could legally do the rescue overwhelming force was the commitment that ourselves” (p. 187). Under Section 13(3) of the supply of currency would be unlimited. the Federal Reserve Act, the Fed is allowed to act under “unusual and exigent circum- stances.” So, it seems that the Fed could 5. Lehman have acted. But there was another argument, “. . . the fall of Lehman was a serious blow, namely that Lehman did not have sufficient shattering confidence around the world” “good” collateral. (See FCIC Report 2011, (p. 212). Should Lehman have been allowed p. 341.)29 Lehman CEO, Dick Fuld, how- to fail? Geithner is clear on this. “Nothing ever, in his written statement to the FCIC is more dangerous during a panic than the (September 1, 2010): “First, there was no sudden liquidation of a major institution capital hole at Lehman Brothers. . . even . . . .” (p. 149). “[I]n a colossal crisis, you the Lehman bankruptcy examiner found never want to allow a messy liquidation of a immaterial differences in the firm’s asset val- major institution [Lehman] unless you can uations. . . . Second, Lehman had adequate draw a circle of protection around the rest collateral” (p. 6).30 This is the issue of valua- of the system’s core, a firebreak to contain tion during a financial crisis, discussed above. the flames. If Lehman failed, and the US Solvency is in the eye of the beholder. In the government publicly proclaimed that we are end, the Fed and Treasury made a decision done with bailouts, rational investors would and it is hard to second-guess them. simply run from other financial institutions” Bailing out banks is not popular when the (p. 179). government does it. But it happens even Geithner’s view is based on his prior cri- without a central bank. Prior to the Federal sis experiences. For example, “Indonesian Reserve, during the National Banking Era, execution [of crisis policies] was a problem, private bank clearinghouses bailed out large but the IMF made mistakes too. The most member banks when they teetered on the damaging may have been forcing Suharto to brink. See Gorton (2012) and Gorton and shut down troubled banks. . . . That triggered Tallman (2014). Geithner, I think, is right to a run on deposits in the rest of the banking see the question of bailouts as central to pol- system. . .” (p. 58). Djiwandono (2005), the icy responses, and his view is consistent with head of the Indonesian central bank at the time, also argues that the IMF-led closure of sixteen banks in November 1997 led to a run 29 See http://www.federalreserve.gov/aboutthefed/ on other banks. section13.htm and Fettig (2008). 30 Also see Report of Anton R. Valukas, Examiner, In re So, why was Lehman not bailed out? Lehman Bros. Holdings Inc., No. 08-13555 (JMP) (Bankr. Bernanke, at his Financial Crisis Inquiry S.D.N.Y. Mar. 11, 2010), http://jenner.com/lehman. 986 Journal of Economic Literature, Vol. LIII (December 2015) the historical record. “This is a classic prob- And he knew that because of his policies lem in crisis response. The overwhelming he “. . . would later be criticized as a walk- temptation is to let the most egregious firms ing source of moral hazard. . .” (p. 145). In fail, to put them through a bankruptcy-type a crisis, “moral hazard” basically is a policy process like the FDIC had for community of implicitly (or maybe explicitly) allowing banks and then haircut bondholders. But banks to fail, and that seems to have been unless you have the ability to backstop every the source of the frustration. “. . . [O]ur crit- other systemic firm that’s in a similar posi- ics didn’t have feasible plans of their own” tion, you’ll just intensify fears of additional (p. 325). His frustration with the “moral haz- failures and haircuts” (p. 306). Without a bail- ard fundamentalists” was that any policy pro- out, the war chest may have to be enlarged, posed to ameliorate a crisis would be open which may not be politically feasible. And to the charge of “moral hazard.” Repeatedly, there is uncertainty about whether the size he says things like: “I got irritated when the of the war chest is large enough. critics offered anxieties without alternatives” The perceived heart of the problem is the (p. 342). I mention this because it seems trade-off between moral hazard creation and that, to the extent that economics had any saving the economy from the destructive influence on the crisis response, moral haz- effects of a large bank failure, a trade-off ard concerns was it. Geithner was very aware of. During the cri- Geithner’s concern seems very legiti- sis, decisions must be made. But, this dichot- mate to me. The most relevant issue here omy of bailing out banks or not is a false one is whether a financial crisis is the time to in general because the best policies would deal with moral hazard, by teaching banks be ones that prevent financial crises, at least lessons by letting them fail or firing their for significant periods of time, as the United managements. It is more important to pre- States did from 1934 to 2007. vent twelve of the thirteen largest U.S. finan- As a practical matter, if I had been Ben cial institutions from failing. The historical Bernanke or Tim Geithner, I would have record seems clear: do not let big banks fail allowed Lehman to fail, but only because in crises. And the counterfactual of Lehman saving Lehman would have resulted in such seems consistent with this. The new reso- a populist backlash that the Fed’s indepen- lution procedures of Dodd–Frank seek to dence would have been compromised for a make such bank failures less disorderly. We long time. Politics is inevitably involved in will see in the next crisis. such decisions, and Congress would likely Moral hazard is not the cause of financial not have passed TARP had it not been for crises. With respect to banks and crises, the Lehman. But, looking forward to the next concept is a tricky one. Did banks engage in crisis, when the question will no doubt arise “moral hazard” prior to the Fed? Are those again, it is worth asking whether Lehman pre-Fed crises different? Why was there should have been allowed to fail (without no “moral hazard” after deposit insurance regard to politics). was adopted in the United States in 1934? Is “moral hazard” a theory of crises under central banks? Bank runs have occurred 6. Moral Hazard throughout the history of market economies, and often when there was no central bank, Geithner did think that “moral hazard” no deposit insurance, and no government was a genuine issue: “The moral hazard risk bailouts. These crises were also about short- [with bailing out Bear] was real. . .” (p. 151). term debt, Diamond’s point. Also, there Gorton: Stress for Success 987 have been long periods without crises even may just be behavior that is consistent with though there was deposit insurance or there the desires of the principals, riskier firms were only a few large banks. The root prob- pay more in compensation—bonuses. Some lem is short-term debt, not moral hazard. firms, i.e., boards of directors and top man- Government policies adopted to address agements, may prefer more or less ­risk-taking, the vulnerability of short-term debt may and investors may sort on this basis. In such engender a problem of moral hazard. And, a world, compensation schemes would look in a sense, the government has caused the different across different banks. We simply problem. But actually, the problem is that don’t know much about any of these issues. the solution to the vulnerability of short-term However, Cheng, Hong, and Scheinkman debt is imperfect. It need not be imperfect. (forthcoming) is an example of recent work The United States did not experience a finan- on some of these issues. cial crisis between 1934 and 2007. Yet, there Rather than describe firms in terms of was deposit insurance and there were large principals and agents, we should investi- banks. How did that happen? To say that gate corporate culture.31 Geithner hints at the empirical evidence on the existence of this, saying: “Throughout my time at the moral hazard is mixed is an understatement. [New York] Fed, we found that the firms Results seem to depend on the time period, with cultures that valued risk management country, the existence of credible bank exam- and risk managers tended to be stronger inations, and on the type of financial inter- and more conservatively financed” (p. 165). mediary. Are bank failures and losses due Risk management and risk-taking propensi- to moral hazard, managerial entrenchment, ties seem (to me) to be intimately related to forbearance, or looting? Some examples of corporate culture. Following the crisis, in the the empirical work on this include: Keeley both houses of Parliament (1990), Akerlof and Romer (1993), Gorton appointed a Parliamentary Commission on and Rosen (1995), Gan (2004), Gropp and Banking Standards “to consider and report Vesala (2004), and Dam and Koetter (2012). on professional standards and culture of the There are probably many reasons why UK banking sector. . .” 32 The report is far banks would not engage in moral hazard. reaching, but has large sections essentially One reason is that a bank’s charter value, on bank culture. Even prior to the crisis, the an intangible asset that is lost if the bank Basel Committee noted the importance of becomes insolvent, provides an incentive not culture and the intertwining with governance to engage in moral hazard. Charter value is (BIS 2006). It seems difficult to change a the present value of rents the bank may get firm’s internal culture and even harder for from limited entry. See Marcus (1984) and regulators to do this. Furlong and Kwan (2006). Or, another rea- Compensation is no doubt related to cor- son may be that the bank’s reputation would porate culture, and in banking this does seem be lost if it were to become insolvent. Finally, important; see Philippon and Reshef (2012). the information the bank has on borrow- But, in economics there is little work on cor- ers is lost if it fails. See Slovin, Sushka, and porate culture. One interesting empirical­ Polonchek (1993). Banks and firms are large, complex, orga- 31 Schein (1985) defines corporate culture as a set of nizations—too complex, it seems to me, to shared norms and values expressed in terms of common be adequately captured by a principal–agent language. 32 See http://www.parliament.uk/business/committees/ model. But, even in the principal–agent committees-a-z/joint-select/professional-standards-in-the- framework, what looks like “moral hazard” banking-industry/news/changing-banking-for-good-report/. 988 Journal of Economic Literature, Vol. LIII (December 2015) example is Carretta et al. (2006).33 Also, see The banks were instructed to calculate Guiso, Sapienza, and Zingales (forthcom- losses, profits, and loan loss reserves over ing). This is an area for future research. the next nine quarters under a baseline sce- nario and under a more adverse (i.e., stress) scenario (see Hirtle, Schuerman, and Stiroh 7. Stress Tests of Banks 2009). The regulators independently made The crisis dragged on. Geithner became their own such projections under each sce- US Treasury Secretary in 2009. Shortly after nario. Comparing a bank’s capital projection taking office, he announced a new initia- to that of the regulators produced the “capi- tive to inspire confidence: stress tests for tal gap.” If there was a significant gap, com- large banks. “The stress test would provide pared to required capital, then the gaps were a form of triage, separating the fundamen- required to be filled with capital plans filed tally healthy [banks] from the terminally ill” by the banks, privately produced capital, (p. 12). “. . . [I]f an unhealthy firm couldn’t and if that could not be done, then through raise enough [capital] from private investors, the Capital Assistance Program (CAP). The government would forcibly inject the miss- backstop for the capital gaps, announced ing capital” (p. 11). The basic idea was to in conjunction with the stress tests was the reduce uncertainty about remaining losses Treasury’s Capital Assistance Program (CAP), on bank assets (see Bernanke 2009c). The “which makes capital available as a bridge to goal now was to produce and reveal infor- private capital” (Geithner et al. 2009).36 mation publicly. “The plan aimed to impose The stress tests did produce new infor- transparency on opaque financial institutions mation, based on abnormal stock returns. and their opaque assets in order to reduce Overall, the banks displayed positive abnor- the uncertainty that was driving the panic” mal returns, though there are some nuances (p. 286). The stress tests are widely viewed (see Peristiani, Morgan, and Savino 2010 as a success. and Bayazitova and Shivdasani 2012). Of the The plan for the stress tests of the nine- nineteen banks stress tested, ten had capital teen largest bank holding companies (about gaps. By November 2009, nine of the ten gap two-thirds of the total US bank assets) was banks had raised sufficient capital privately announced by the US Treasury Department, to close their gaps. GMAC was the one Federal Deposit Insurance Corporation, exception; it met its remaining gap via TARP Office of the Comptroller of the Currency, (Fed Press Release November 9, 2009). Office of Thrift Supervision, and the Federal The widespread­ reaction to the stress tests Reserve Board in a joint ­statement on February was to hail them as having been important 10, 2009.34 On April 24, 2009, the Federal in ending the crisis. Bernanke (2013, p. 2): Reserve Board released a twenty-page­ white “In retrospect, the SCAP stands out for me paper describing the procedures employed as one of the critical turning points in the in the stress test. 35 And on May 7, 2009, the financial crisis. It provided anxious investors results of the Supervisory Capital Assessment with something they craved: credible infor- Program (SCAP) were released. mation about prospective losses at banks. Supervisors’ public disclosure of the stress 33 With respect to theory, see Camerer and Vepsalainen test results helped restore confidence in the (1988) and Kreps (1990). 34 See http://www.federalreserve.gov/newsevents/press/ bcreg/20090223a.htm. 35 See http://www.federalreserve.gov/newsevents/press/ 36 See http://www.federalreserve.gov/bankinforeg/ bcreg/bcreg20090424a1.pdf. stress-tests-capital-planning.htm. Gorton: Stress for Success 989 banking system and enabled its successful private bank clearinghouses sometimes sent recapitalization.” 37 teams to examine some individual member FOMC Governor Daniel Tarullo (2010) banks during suspension periods. Usually, points to three reasons for the success the banks were declared solvent, but no of the stress tests. The test results were details were ever released. (See Gorton and viewed as credible, which he attributes to Tallman 2014.) their transparency in releasing details about There are many unanswered questions test assumptions and methods. Second, he about the stress tests. Were the stress tests argues that “the results were released at a a success? How do we measure success? If time when uncertainty about bank conditions they were a success, why were they a suc- was very high, and some market participants cess? If hiding information reduces stigma, feared the worst.” Finally and perhaps most why does releasing information create posi- importantly, part of the announcement and tive results? Goldstein and Leitner (2013) is program for the tests was that “the Treasury an example of some research on these ques- stood ready to make capital available to any tions, but they remain an important mystery. SCAP bank with capital needs through the There may be some tentative clues. CAPP [the Capital Asset Purchase Program] Perhaps credibility is the key. Although the if they were unable to raise private capital.” model was never revealed, it seems that the In other words, the war chest was available. results were believed and, like Roosevelt’s And, it turned out that none of the banks fireside chat, seem to have resulted in received CAPP funds. increased positive expectations. But would The stress tests seem paradoxical. All the the stress tests have worked just after the Fed’s special lending programs protected Lehman bankruptcy or, say, the month the identities of the borrowers to avoid before Lehman? Clearly, we do not know. stigma. The Fed defended itself against the Roosevelt’s fireside chat came in the midst Bloomberg suit by describing the devastat- of the nationwide panic. However, no weak ing effects of stigma. And, steps to prevent banks were identified. The stress tests came bank identities from being revealed upon very late in the crisis; results were announced borrowing at central bank or private clear- on May 7, 2009, but the date of the last crisis inghouse crisis lending programs has been event on the timeline of the financial crisis a feature of crisis policy responses for over produced by the Federal Reserve Bank of St. a century. The contrast with the stress tests Louis is March 19, 2009.39 Gorton, Metrick, is dramatic. The stress test results were and Xie (2014) also finish their crisis dating made public. See Board of Governors of the prior to the stress tests. The NBER dated Federal Reserve System (2009b). But, the the trough of the recession at June 2009. It model of the ­regulators was not made public. may be that at that point in the crisis, the So, interestingly, while results are made pub- tests served to eliminate any remaining lic, the process of achieving the results is not uncertainty providing an ending point for made public.38 In the nineteenth century, the crisis. Maybe a lot of uncertainty about whether the government could backstop the entire financial system had already been 37 In contrast, the stress tests in Europe are widely viewed as having been a failure because the tests did not attenuated. This is clear with respect to the include sovereign debt. See, e.g., Blundell-Wignall and Slovik (2010) and Ahmed et al. (2011). 38 The banks report their calculations in Federal ccar/November-1-2013-Instructions-for-Submission-of- Reserve Form Y-14A, which is not made public. See Capital-Plans.htm. http://www.federalreserve.gov/bankinforeg/stress-tests/ 39 See: http://timeline.stlouisfed.org/index.cfm?p=timeline. 990 Journal of Economic Literature, Vol. LIII (December 2015)

800,000 700,000 Lending Lehman failure 600,000 Stress test D

S 500,000 U

s 400,000 o n i l

i 300,000 M 200,000 100,000 —

20-Jul-07 20-Jul-09 20-Dec-0720-Jan-0820-Feb-0820-Mar-0820-Apr-0820-May-0820-Jun-08 20-Aug-0820-Sep-0820-Oct-0820-Nov-0820-Dec-0820-Jan-0920-Feb-0920-Mar-0920-Apr-0920-May-0920-Jun-0920-Aug-0920-Sep-0920-Oct-0920-Nov-0920-Dec-0920-Jan-1020-Feb-1020-Mar-10

Figure 1. Total TAF, TSLF, PDCF Lending Outstanding

Source: Federal Reserve System.

Federal Reserve’s special lending programs. the discipline on banks to be able to actu- Figure 1 shows the total lending outstand- ally implement the stress tests. It requires, ing for the sum of the Term Auction Facility for example, that IT systems communicate, (TAF), the Term Securities Lending Facility a major problem for some banks. Further, (TSLF), and the Primary Dealer Credit it offers a template for how the tests can Facility (PDCF). The first vertical line is become broader, for example incorporat- the date of the Lehman bankruptcy and the ing positions. The stress tests will second vertical line is the date that the stress become more complex and comprehensive test results were announced. It seems that over time. And the precrisis-type bank exam- the lending was winding down. While many inations will continue. countries also introduced stress tests, it is not For use in noncrisis times, perhaps most clear that the panel of countries will help us importantly, stress tests are not rules based; solve this puzzle. We have no stress tests ear- the banks do not know exactly how the reg- lier in the crisis. ulator’s results are computed, so it is hard Another major reason that the stress tests to game the tests. Oversight of banks is were hailed, I think, has to do with the new now largely rules based. Notably, capital methodology for examining banks, a new requirements depend on rules, in particu- supervisory tool.40 Here I see little debate. lar with the Basel III risk weights for assets In a way, the tests are more rigorous than and bank internal models which can be precrisis bank examinations, although on-site used to determine risk weights. Rules invite examinations have no substitute. The tests gaming by banks. The gaming may have are forward-looking and compute results for started already. The Bank for International stress scenarios, as well as a baseline sce- Settlements (2013) noted that there was nario. It is a major step forward to impose considerable variation across banks in aver- age risk-weighted­ assets for credit risk. With 40 See Board of Governors of the Federal Reserve respect to internal bank models, which can (2014) for the current state of the stress tests. be used to assess the risk weights for some Gorton: Stress for Success 991 asset classes, Behn, Haselmann, and Vig not have been involved in the stress tests (2014), studying Germany, found that inter- had they been in existence then. Stress tests nal risk estimates used for regulatory pur- are only one tool. While the data are limited, poses “systematically under-predict actual economists should pay careful attention to default rates” (abstract).41 Recent research these ­stress-tests-related issues. on risk weights includes Acharya, Engle, and Pierret (2014) and Glasserman and Kang 8. Conclusion (2014). Under a rules-based system, the banks Timothy Geithner’s book raises many have discretion to try to evade rules, to find important points for future research and gray areas, and the regulators are in the economists have a lot of work to do to pre- business of trying to catch them (Haldane pare for the next crisis. Most importantly, 2013). But, the banks do not know the mod- in a financial crisis, Geithner’s overwhelm- els that the bank supervisors use in stress ing force argument for restoring confidence tests. With stress tests, only the regulators seems to me to be correct. If confidence is know the models and so the discretion has the information insensitivity of short-term been shifted in their direction. Banks cannot debt, then it seems that re-creating confi- game a model they do not know. This is very dence amounts to using overwhelming force important. to convince people that the backing of the Still, there are many issues with the stress government is unquestionably sufficient to tests. How do we validate stress tests, for buy the banking system. The government example? And, what exactly is the role of itself is information insensitive in that people the stress tests? Are they microprudential or unquestionably believe that the government macroprudential? In other words, should the can tax enough in the future.43 Whether tests mostly be used to find weak banks, or the war chest is explicit (e.g., TARP) or should the tests focus on finding macroeco- implicit (e.g., Draghi’s statement), it must nomic fragilities? Whether the stress tests be perceived as large enough to be credible. can predict future vulnerabilities is not clear. Managing expectations, in the first instance, In one study, it turned out that the majority of is about the size of the war chest backing the such tests conducted around the world prior financial system. Roosevelt’s fireside chat to crises concluded that the banking sys- may be an example of this. But, how do we tem was robust. See Alfaro and Drehmann know how large the war chest should be and (2009).42 Also, see Ong and Pazarbasioglu what form should it take? (2014). Political constraints are naturally an issue, The tests will get better over time, but in especially when policymakers ask for hun- any case, the regulators must choose the right dreds of billions of dollars to finance crisis models and the right scenarios. This seems responses. It is unfortunate that the crisis had quite difficult. See, however, Glasserman, to become so bad for a consensus to form and Kang, and Kang (2015). Prior to the financial then to allocate sufficient resources. But nei- crisis, the set of institutions at the core of the ther the Fed nor the Treasury seems to have crisis were not regulated banks and would wanted TARP prior to Lehman. That was a failure to understand the unfolding events. Although described as a bank run early on, 41 Also, see Le Leslé and Avramova (2012). 42 The study is based on results from countries involved in the IMF Financial Sector Assessment Program in 2005, 43 Obviously, this is not true for all governments at all 2006, and the first half of 2007. times. 992 Journal of Economic Literature, Vol. LIII (December 2015) the full ramifications only became clear to Autore, Don M., Randall S. Billingsley, and Tunde the Fed and the Treasury with Lehman. This Kovacs. 2011. “The 2008 Short Sale Ban: Liquidity, Dispersion of Opinion, and the Cross-Section of raises the issue of what a “crisis” is and how Returns of US Financial Stocks.” Journal of Banking it unfolds through time. This is a fundamen- and Finance 35 (9): 2252–66. tal starting point. Economists seem confused Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. London: Henry S. King. about this. Government efforts to address Bai, Jushan. 2010. “Common Breaks in Means and the vulnerability of short-term debt do not Variances for Panel Data.” Journal of Econometrics cause crises. Short-term debt is vulnerable to 157 (1): 78–92. Bank for International Settlements. 2013. “Analysis of runs. That is the problem. Risk-Weighted Assets for Credit Risk in the Banking The stress tests were a major innovation Book.” Basel: Bank for International Settlements. during the crisis and will be important in Basel Committee on Banking Supervision, Bank for International Settlements. 2006. “Enhancing Corpo- the future in some form, in noncrisis times rate Governance for Banking Organisations.” Basel: if not during crises. It is not clear how and Bank for International Settlements. why they were effective during the crisis— Bayazitova, Dinara, and Anil Shivdasani. 2012. “Assess- ing TARP.” Review of Financial Studies 25 (2): or were they? How do they work when 377–407. every other policy response program main- Beber, Alessandro, and Marco Pagano. 2013. tains the identities of banks secret? 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