What was new prior to the crisis was the extent to which maturity transformation and financial intermediation had migrated outside of commercial banks. The growth of what we call the shadow banking system occurred largely without the types of safeguards—robust prudential regulation, deposit insurance, lender of last resort—that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the financial system. The systemic risk created by this gap in coverage was not well recognized by regulators or the private sector prior to the global financial crisis. Market participants had little incentive to internalize the negative externality of the run-risk created by their collective choice of finance, and they made erroneous assumptions about the liquidity of asset markets and the capacity and willingness of banks to distribute central bank liquidity to the wider financial system during periods of stress. 

The financial crisis is behind us, thankfully, but not far behind. The image in the rearview mirror is still largeand perhaps closerthan it appears. The Federal Reserves history is important, but it is only helpful to the extent that it positions us to consider how we might address the considerable challenges that await the central bank in the years to come. Those challenges include normalizing monetary policy, effectively supervising the largest financial institutions, and ensuring a safe, efficient and accessible payments system.

The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.

I have tried to offer some perspectives on the nature of the macroeconomic situation during 2008.
At the one-year anniversary of the financial crisis, in August 2008, it appeared that the U.S. had weathered the crisis reasonably well, and that continued slow growth was likely.
However, the effects of the commodity price boom during the preceding year, peaking in July 2008, contributed to a slowing economy during the third quarter of 2008.
This greatly exacerbated the financial crisis and led to multiple financial firm failures.

Bullard noted that some analysis suggests that the sooner policymakers set the policy rate to zero, the sooner the economy will recover and the sooner interest rates can be returned to normal. “I have seen no evidence that this is true during the last five years,” he said. “Instead, I think the December 2008 FOMC decision unwittingly committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown consequences for the macroeconomy,” Bullard cautioned.

An important feature of shadow banking is the historical and continuing involvement of commercial and clearing banks--that is, more "traditional" banking institutions. For example, commercial banks sponsored securitizations and ABCP conduits, arrangements which, until recently, permitted those banks to increase their leverage by keeping the underlying assets off their balance sheets. Clearing banks stand in the middle of triparty repo agreements, managing the exchange of cash and securities while providing protection and liquidity to both transacting parties…

Because of these and other connections, panics and other stresses in shadow banking can spill over into traditional banking. Indeed, the markets and institutions I mentioned--the repo market, the ABCP market, and money market funds--all suffered panics to some degree during the financial crisis. As a result, many traditional financial institutions lost important funding channels for their assets; in addition, for reputational and contractual reasons, many banks supported their affiliated funds and conduits, compounding their own mounting liquidity pressures.

[A recent study] suggests that conditions would have been even worse in the absence of the Federal Reserve's securities purchases: The unemployment rate would have remained persistently above 10 percent, and core inflation would have fallen below zero this year. Of course, considerable uncertainty surrounds those estimates, but they nonetheless suggest that the benefits of the asset purchase programs probably have been sizeable.

The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities...

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures. In reflecting on this experience, I have gained increased appreciation for the challenges faced by policymakers in emerging market economies who have had to manage large and sometimes volatile capital inflows for the past several decades.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

60 Minutes: Is there anything that you wish you'd done differently over these last two and a half years or so?

Bernanke: Well, I wish I'd been omniscient and seen the crisis coming, the way you asked me about, I didn't. But it was a very, very difficult situation. And the Federal Reserve responded very aggressively, very proactively.

 I would argue that the recent financial crisis was more a failure of economic engineering and economic management than of what I have called economic science...

I don't want to push this analogy too far. Economics as a discipline differs in important ways from science and engineering; the latter, dealing as they do with inanimate objects rather than willful human beings, can often be far more precise in their predictions

We will soon give notice to the third anniversary since the onset of the global financial crisis. As we mark this occasion--and continue to witness shocks arising intermittently and unevenly--it might be worth debunking some popular views that have become part of the crisis narrative. In their stead, I will begin with what I believe are some truths, perhaps hiding in plain sight all along.

Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made in the USA, but first manifested itself here. The volatility in financial markets is not the source of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy. Excessive growth in government spending is not the economy's salvation, but a principal foe. Slowing the creep of protectionism is no small accomplishment, but it is not the equal of meaningful expansion of trade and investment opportunities to enhance global growth. The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.

It is interesting that, just a few years ago, strong countercyclical policy actions of the type taken by Korea would not have been recommended for an emerging market country during a period of crisis, and might not even have been feasible. In earlier crises, foreign investors were not inclined to give emerging market policymakers the benefit of the doubt when they promised low inflation and sustainable fiscal policies. Attempts to support economic activity through conventional expansionary policies thus risked a vicious circle of capital flight, exchange rate depreciation, higher inflation, a worsening balance of payments, and more capital flight. As a result, monetary policymakers in emerging markets often reacted to crises--such as the Asian financial crisis of the late 1990s--by raising rather than lowering policy rates, in order to defend the value of the currency, slow capital flight, and bolster the credibility of monetary policy. Likewise, the scope for fiscal expansion was severely limited by concerns about medium-term fiscal sustainability.

Why was this crisis different? In particular, why was the Bank of Korea able to respond in a countercyclical manner this time, reducing rather than raising the policy rate in response to the downturn? One important difference, of course, was that this crisis originated in advanced economies, not in the emerging market economies. Financial institutions in Korea and other emerging market economies had little direct exposure to structured credit products and other troubled securities and entered the crisis in relatively sound condition.

In addition, following the Asian financial crisis in the late 1990s, Korea and a number of other countries in Asia, Latin America, and elsewhere took decisive steps to strengthen their macroeconomic frameworks and financial systems... 

Improvements in the Bank of Korea's monetary framework served the country well during the crisis and are likely to provide additional benefits in the future. Over the past decade, many emerging market economies, including Korea, have reoriented monetary policy toward domestic price stability and away from a focus on stabilizing exchange rates. The Bank of Korea, indeed, adopted a formal inflation targeting regime in 1998. Since then, the exchange value of the won has become more flexible, inflation has declined to an average of about 3 percent, and--as I have discussed today--the ability of the Bank to conduct appropriate countercyclical monetary policies has increased.

MR. BERNANKE …At one point, we got an offer from Bank of America. They said, “We’ll buy them if you’ll finance” -- I’m making up numbers now, but rough order of magnitude –- “if you’ll finance an $80 billion portfolio for $80 billion,” except its actual market value was $50 billion. So in other words, they wanted a $30 billion gift, essentially, in order to make that acquisition. We did not have the legal authority to do that, not to mention the political backing.

Vice Chairman Thomas: And you wouldn’t have done it, anyway.

MR. BERNANKE: That’s right. And it would have been a bad decision, anyway, because we had so much -– so many other firms already on the brink, coming down the pike. So I will maintain to my deathbed, that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority.

It is important not to take the wrong lesson from the finding that more open economies were more severely affected by the global recession.  Although tighter integration with the global economy naturally increases vulnerability to global economic shocks, considerable evidence suggests that openness also promotes stronger economic growth over the longer term.  Protectionism and the erecting of barriers to capital flows should thus be strongly resisted.