In my opinion, the root cause of the problems was the underpricing of risk as the financial sector interacted with nonfinancial sectors. On the lending side of the financial sector balance sheet, underpricing of loans relative to true risk resulted in a buildup of leverage in the household sector that left lenders vulnerable to declines in collateral values and debt servicing capacity. On the borrowing side, households ended up with some assets--like shares in money market mutual funds--that weren't as liquid as they were thought to be; when money funds began to worry about the liquidity of their assets, like asset-backed commercial paper, and when households and businesses tried to use their perceived liquidity, the resulting fire sales accentuated asset price declines and transmitted problems from one sector to another.

I will leave it to economic historians to assess whether the Panic of 2008 was more anomalous than the period of prosperity that preceded it. I believe that the categorization of recent events as deviant, ultimately, will depend on what happens next. That is, if policy changes cause future economic performance to suffer, then the boom of the last generation may, regrettably, turn out to be more exceptional than the bust.

I expect to see further deterioration in some areas, notably job market conditions, before our policies gain full traction. Weak economic news by itself would not imply that we have misjudged the size of our latest actions. In my view, it would take a significant deterioration relative to our outlook for me to view our current policies as inadequate.

Credit market conditions have eased generally, especially in commercial paper and interbank lending markets. While this is no doubt due in part to the broader moderation in economic conditions, I think it also stems partly from a decline in the underlying uncertainty about credit losses and the conditions of our larger banking organizations. The recently completed "stress test" for the 19 largest banks also contributed to the improvement in financial market conditions. While many of these banks still face significant losses, the stress test results dispelled some concerns about gloomier loss estimates and greater government ownership, and required banks to create plans to ensure that they have enough capital to absorb those losses. A number of banks appear to have made substantial progress already in bolstering their capital.

[A]t the onset of the current crisis, the financial regulatory system had accommodated the growth of capital market alternatives to traditional financing by relaxing some restrictions on bank activities and virtually all restrictions on affiliations between banks and non-bank financial firms. In place of the superseded restrictions were capital requirements focused on credit and market risk, along with a greater emphasis on supervision and risk management, especially at larger firms. These legal changes facilitated a wave of mergers and acquisitions that created a number of very large, highly complex financial holding companies centered on a large commercial bank. These were subject to prudential regulation. At the same time, there was a group of very large, significantly leveraged "free-standing" investment banks whose market practices were regulated by securities laws, but were not subject to prudential regulation.

Examination and understanding of the role of off-balance sheet activities deserves significantly more supervisory attention, going forward. It will be important to ensure that capital held for offbalance sheet exposures is commensurate with the risk that they pose.

This recession is often described as the worst in post-World War II history, and that may very well be correct.  From it will flow a host of policy issues that will require careful review and hard choices if we are to assure our national economy's long-term strength and vitality.

Right now, the financial system remains impaired, and there is considerable rhetoric about a so-called credit crunch. To be sure, some borrowers are encountering substantial difficulty in obtaining funding, but conversations with numerous bankers and their customers reveal a diverse set of circumstances, ranging from “business as usual” on the one hand to appreciable credit restriction on the other. One size clearly does not fit all, and it is important to recognize that the demand for credit from some sectors appears to have diminished, and its composition has shifted as well.

In my time at the Federal Reserve, starting in 2005 and working predominantly under the chairmanship of Ben Bernanke, my colleagues and I have been focused primarily on finding a way to undo past errors and mend the system. I believe that the initiatives taken by my fellow “banksters” at the Federal Reserve prevented us from falling into the chasm of an economic depression.

Looking back on the crisis thus far, however, I believe that a strong case can be made that the financial safety net, especially those parts that were more implicit and perceived than explicit and written into the laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing. While deployment of the financial safety net is often viewed as an essential response to the financial crisis, I believe we need to give serious thought to the extent to which the safety net was actually a significant cause of the crisis.

The various ways, both explicit and implicit, in which banks stood behind their off-balance sheet arrangements ultimately meant that the loans and other assets that ostensibly were moved off the balance sheet had the ability to come back onto banks’ balance sheets. You might say that they became “boomerang assets,” in the sense that they would have been expected to boomerang back to the banks when investors turned away from the obligations of off-balance sheet entities.

Had there existed the authority and procedures to resolve Lehman outside of bankruptcy proceedings, there may have been a much more orderly “wind down” of Lehman’s operations. Of course, the Lehman failure suggests that even with resolution powers in place this would have been a very challenging situation – Lehman would have been difficult to wind down, in part because of the scope of its global operations.

I think it is important to note that three of the largest exposures were held by a commercial bank, an investment bank, and a foreign bank, which likely made the potential problem less obvious to any single regulator.

Historical experience shows that, once begun, a financial panic can spread rapidly and unpredictably; indeed, the failure of Lehman Brothers a day earlier, which the Fed and the Treasury unsuccessfully tried to prevent, resulted in the freezing up of a wide range of credit markets, with extremely serious consequences for the world economy. The financial and economic risks posed by a collapse of AIG would have been at least as great as those created by the demise of Lehman. In the case of AIG, financial market participants were keenly aware that many major financial institutions around the world were insured by or had lent funds to the company. The company's failure would thus likely have led to a further sharp decline in confidence in the global banking system and possibly to the collapse of other major financial institutions.

[T]he conditions for government assistance need to be carefully calibrated to protect the taxpayer while still allowing the policy objectives to be accomplished. Firms might hold back on accepting government help if they saw the cost of meeting the conditions as greater than the benefit of the assistance or if they were concerned that the conditions might change in an undesirable way after the assistance had been accepted. Such hesitance could impede the effectiveness of government programs and slow the recovery of jobs and income.