Video
The New York Stock Exchange on September 17, 2008. Photo: Mario Tama/Getty Images.

Lessons for the Crisis Fighters

One challenge in studying a once-in-a-century financial crisis is that it only happens once in a century; lessons aren’t easily passed down to the people who will face the next one. Yale SOM’s Andrew Metrick and a team at the Yale Program on Financial Stability are studying the global financial crisis of 2007-09, working to create the knowledge and tools to prepare the next generation of policymakers who find themselves in the eye of a monetary maelstrom. 


The 10th anniversary of the collapse of Lehman Brothers produced uncounted retrospectives, commentaries, reminiscences, and op-eds. There’s no doubt that the event, which sparked the worst months of the global financial crisis of 2007–09, was one of historical importance. But its history is still being written—and the future of the financial system may depend on what we can learn from that history. 

In observation of the anniversary, the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution co-sponsored with the Yale Program on Financial Stability (YPFS) a two-day conference on the response to the crisis, which featured a panel discussion with three of the most prominent leaders of the U.S. government’s efforts to keep the economy working. These three—Ben Bernanke, then Chair of the Federal Reserve; Hank Paulson, then Treasury Secretary; and Timothy Geithner, then President of the Federal Reserve Bank of New York and later Treasury Secretary—could narrate for the audience what they’d thought and felt as the pillars of the global economy seemed to be shaking around them.

Paulson described waking up in the middle of the night thinking about the problems they faced. “I would look into the abyss and just, you know, see food lines, see a second Great Depression, wondering if one more institution went down how would we ever put it all back together again,” he said. 

“I just remember that mix of crushing burden and responsibility,” said Geithner. “I think the hardest thing was sitting at the table with my wife in the morning with her reading about what we were doing, and just seeing on her face that mix of despair and doubt.”

The three talked through some of the specifics of the response to the crisis—whether they should have (or could have) made more efforts to support the housing market, the decision to keep major financial institutions from crumbling by injecting capital into the system, and the importance of global cooperation among regulators as the crisis continued. A recurring theme in their comments was the uncertainty they faced—both because of the scale and complexity of the modern financial system and because none of them had lived through such a severe financial shock before. 

They also sought to draw lessons from their experience, knowing that the GFC will not be the last financial crisis.

“I think the right way to think about the risks in the system is that there’s no way to anticipate the full range of things that can cause a system to break down,” said Geithner. “You should design the system so it’s robust enough and resilient enough to withstand as broad a range of tests or shocks, whatever their source, as is possible. And that’s what the reforms post-crisis have tried to do. But as I think we learned in the crisis, that requires not just a strong set of defenses in terms of capital and funding stability, but it requires a strong emergency arsenal when those defenses fail.”

Bernanke pointed to the work that YPFS is doing to examine the results of a wide range of crises throughout history as an important step forward. “The basic economics is kind of the same across panics. It’s just that the institutional setups and the details are different, but we can learn,” said Bernanke.

Andrew Metrick, the Janet L. Yellen Professor of Finance and Management at Yale SOM and the director of YPFS, has worked extensively with Geithner, Bernanke, Paulson, and other key actors on projects aimed at turning their experiences into useful guidance for future crisis fighters. (Read more about YPFS.) Metrick spoke with Yale Insights about some of the emerging findings from that work and how well prepared the financial system is for the next major test. 


What are some of your conclusions after all the events related to the 10th anniversary of the collapse of Lehman?

At this stage, we certainly don’t have conclusions, but we have some themes. Let me frame what I would say is the biggest one at this stage, which is that there is a tension between two things that all governments face when fighting a crisis. One is the very real desire to punish people who may have taken on a lot of risks, perhaps imprudently, or who have made mistakes. Or you just think, “Look, they were going to get the upside, so they should get the downside, too.” Part of this is what Tim Geithner calls Old Testament justice—the feeling of what is right. But part of it is the honest belief that if you want to avoid having financial crises in the future, you need to make sure that people who have taken too much risk are going to feel the consequences of their actions.

The other side of the equation is that in a crisis moment, it’s often very hard for governments or investors to separate out who really is in trouble, and who is just being carried along with the crowd. So when you get a run on a bank, perhaps because that bank has taken on too much risk and has real problems, it’s simpler for people to just take their money out of all of the other banks rather than spend weeks and months trying to figure out which bank is actually healthy. But the government has to protect the system even when it is not clear which banks are really weak, because they all are at risk of being tainted by the one that acted imprudently.

But that is not easy to do. In a crisis, institutions that are participating in the markets are always looking for ways to demonstrate that they are healthy. And so, whenever a government puts into place a program that might help some institutions, strong institutions immediately want to say, “We don’t need it,” which stigmatizes the program. Therefore, any institution that goes for that help, that uses the program,  is treated in the market as though it were about to fail. 

So it’s really quite difficult to address the problem. If you know that many, many institutions are really solvent but are in desperate need of liquidity, even if you make liquidity available to those institutions, they may not use it because of the stigma that might attach. Simply by making use of that liquidity, those institutions might be telling the market that they’re much worse off than they are. So they’re reluctant to even use the programs put in place to help them. 

One analogy is to firefighting: Some people’s houses are on fire because of mistakes they made. Some people’s houses are on fire because of mistakes other people made. And, if you don’t have a fire department, you can’t rescue any of them. And if you stigmatize everybody who the fire department helps, a lot of innocent people will end up not being able to get help.

That tension is very acute. And in a financial crisis, the debate comes down to people’s core beliefs about how important Old Testament justice is versus how important it is to rescue the system.

Is Old Testament justice useful in a crisis?

What we’ve discovered through just looking at the examples we’ve looked at so far is that meting out Old Testament justice in a way that people weren’t expecting, in the midst of a crisis, tends to make things worse without the benefit that you think you might get. Some countries were much tougher on their bankers than others. The United Kingdom was fairly tough on the senior management of banks and more aggressive in going after people for criminal penalties. But the United Kingdom had pretty much the same reaction to the government’s actions as we had here in the United States, where we didn’t mete out as much Old Testament justice. You don’t see any benefit. 

There were other cases: In the United States the case is Washington Mutual, where the bond holders got a big unexpected hit when the government came in to clean it up. In Cyprus there was an attempt by the international community to get depositors who thought they were insured to pay for some of what had happened. All you do with that kind of action in the midst of a crisis, it seems to me, is scare people and make them panic more. And you don’t get the benefits that you think you’re getting by dissuading future risk-taking, because these things happen so rarely that after 20 years or 30 years has passed, people haven’t  learned the lessons that you thought you taught. 

It’s much easier to tell when something is a failure than when it’s a success. It’s easy to tell that you designed a program in an attempt to do x in the hope that the banks would respond with y, and you observe that x never happened and the banks didn’t respond with y. And that’s a pretty good sign that the way you designed this program was ineffective. 

It’s harder, if you do observe that x happened and the banks did y, to know for sure that it was x that caused the banks to do y. I expect that a lot of what we’re going to uncover with our project are going to be things not to do rather than things to do. But I think that will be really helpful. To have a conversation in the heat of a crisis that rules out a bunch of options that are likely to turn out to be terrible would be a big help to decision makers when they’re faced with these types of problems.

Would you say the rules are different within a crisis? 

When you are fighting a crisis, you are in a different kind of situation than if you’re just facing the failure of a single institution. A lot of countries have put into place automatic processes that will take place if a large financial institution fails. Many of these processes were not in place prior to the global financial crisis. I think that these processes will work really well if it’s one large institution that’s gotten in trouble for idiosyncratic reasons. They made some mistakes, they had some fraud, they made a bad bet, and they’re failing—these are really good processes to have. 

I would say there’s skepticism about whether those processes that have been set up will work if five or six large institutions need to go through them at once. In a systemic crisis—meaning you are concerned that a big chunk of your financial system might be insolvent, and because of that concern, people are running from it—a lot of the regular things that we’ve put in place to handle idiosyncratic failure might turn out to be counterproductive.

It sounds like part of what you’re trying to do is create the memory that can stretch from one crisis to the next.

Crises are not seen all that often, and our work is premised on the idea that we have something to learn from past crises for future crises. You do get a wide variety of opinions on this. Most people will start off telling you, “Well, it won’t be the same next time. It won’t be the housing market. It’ll be something different.” To which my first response is: “Since World War II, it’s always involved the housing market, so there’s a good chance it will still involve the housing market.” But it won’t be exactly the same kind of crisis. Some people believe it’s all different, and you end up just fighting the last war.

“We’ve spent a lot of the political capital that we had to be able to make a significant intervention into the financial sector.”

I would say that the premise of the project is that old cliché “history doesn’t repeat, but it rhymes.” So what we see in looking at historical crises is that there are a lot of commonalities. It always has to do with runs on short-term money-like securities, always. It always seems to have to do with a fair amount of leverage that has built up in the system. And it seems to, as a general pattern, involve the government coming in fairly late to act. 

If you read about the Barings crisis in the United Kingdom in 1890, and you take out some of the anachronistic words, you could be reading about what happened in the United States in 2007 and 2008. So, on that premise, we would like to codify what’s out there and what we know. 

You wouldn’t want the director of FEMA to think every hurricane is different. They happen in different places, but flooding brings some common problems, and high winds bring some common problems. So that’s what we want to do for crisis, how we want people to think about them. And we think that the next generation of crisis fighters should have a body of knowledge of things that worked and didn’t work in the past. And then they would use their human judgment to decide how to apply that knowledge to the specific situation that’s in front of them.

How prepared are crisis fighters now compared to where they were 10 years ago?

I think there’s some good and some bad. The good is that memories of what we did are still relatively recent and some of the mistakes that were made are unlikely to be repeated by these people simply because it’s the same people. In some cases, we’ve gotten powers that we didn’t have before that are useful to have. And specifically, in the United States, we now have—we have a method by which we can liquidate a firm like AIG or Lehman Brothers if it were to collapse today, rather than going through a very messy bankruptcy with a code that’s not designed for a financial institution. So that’s a good thing.

We also have in the United States,  a bit more oversight, and we’ve used that oversight to make sure that at least a core of the system is much better capitalized than it used to be. So, in that respect, we’re better prepared than in our recent experience. But in some respects, we’re in worse shape. We’ve taken away some of our most powerful tools. We’ve taken away the ability of the Federal Deposit Insurance Corporation to make broad-based guarantees of bank debt, which turned out to be something very helpful in the financial crisis. 

We’ve somewhat weakened the ability of the Federal Reserve to do emergency lending to nonbanks. But perhaps most importantly, we’ve spent a lot of the political capital that we had to be able to make a significant intervention into the financial sector. The public is angry, and there are a lot of reasons for them to be angry. That provides a lot less room to maneuver were we to get into trouble again. And that’s not just the case in the United States, but all over the world.

So, I think it’s a mixed bag. It’s unlikely we’re going to be able to do very much about our legal authorities in the near future. It’s unlikely we’re going to be able to do much about the anger and the political capital that exists. But I think we can do something about codifying what we’ve learned about being prepared at an institutional level, so we don’t have to invent things on the fly but rather, we can set up things that have been pre-programmed to be set up.

How important were the individuals who made decisions during the crisis?

I believe that we were lucky in the last crisis. No matter what the people fighting the crisis had done, we would have had a very, very angry electorate and a very angry citizenry—in many cases, for good reason. So, I’m glad that those who fought the crisis were basically successful at the technical aspects of fighting the crisis. I think we’d have the anger anyway, but we might have had the anger and a depression.

I do credit the particular individuals; you never really know how people will react. Take someone like Hank Paulson—going into it, I wouldn’t have guessed that he would prove to be so effective in his role and on that team. His background suggested he was a Wall Street guy. Well, he didn’t behave like a Wall Street guy. He behaved like a public servant. And he behaved on a team of other people as a fantastic teammate. And Ben Bernanke—it’s not surprising that he knew as much as he knew. He was a scholar of the Great Depression. But he had never been put in a situation that required that level of courage before. Who knew that a mild-mannered professor could show that level of courage? These folks were untested going into the crisis, and they came through with flying colors. 

It’s impossible to design in advance a set of crisis-fighting tools that are independent of the quality of the people who will be exercising them. You can’t come up with a military strategy that will work independent of the quality of your generals, despite our desire to do so. So I think it’s important that we have good people in those roles. I would say that the people who are in those roles today are qualified people and it wouldn’t surprise me at all if they stepped up if we had a crisis. They’re untested, but so was the group that we had prior to the crisis.

Hank Paulson said at the Brookings conference that we just had, “I wouldn’t bet against the United States and its institutions in a crisis.” We have a way of coming together in a crisis and I certainly hope that we continue that going forward. The Federal Reserve has been an institution made up of serious professionals for a long time, and that has continued in this administration. The people who are there are quality people. 

Do you think government’s gotten enough credit for the actions it took in the crisis?

Having just read a whole lot of these 10-year anniversary stories, I would say that they’re getting some of it right, which is at least a huge improvement over where we were 7 or 8 years ago. I would say that the median story by serious journalists and op-ed writers goes something like this: The regulatory powers that be were perhaps not alert enough about the buildup of all these terrible things. When the terrible things happened, they reacted in what has turned out to be a very, very powerful and effective way to prevent a depression. And that was a battle that they won. Nevertheless, as a society, we lost the war because the post-crisis hangover, both economic and political and societal, has been very, very painful. 

That’s double edged, right? Lost in that is the question about the counterfactual. I don’t see how in 2005 and in 2006 there was a political will to act in a way that would have headed off the crisis—even if there was more of a recognition that it was coming. And I don’t think there’s anything they could have done that would have resulted in us having a significantly less angry and damaged country post crisis. There might have been things around the margins, small things, second-order things. But not first-order things.

So in that respect, I think that the government’s starting to get the appropriate credit for the things they did right. They’re still blamed, I think unfairly, for some of the things that went wrong. And that’s not to say they were perfect, but just that they’re an easy target for a lot of structural problems that existed in the country and that would have existed whatever the leaders had done at that time.

Janet L. Yellen Professor of Finance and Management