American International Group was characterized as part of the world of “shadow banking” that played a key role in the catastrophic economic downturn of 2007-2009 by Federal Reserve Board chairman Ben Bernanke today in a speech where he discussed the Fed’s response to the financial crisis.
He said AIG’s problems in the fall of 2008 exposed weaknesses in the statutory and regulatory framework for the "shadow banking sector", and “meant that in practice they were inadequately regulated and supervised.”
He put AIG in the same category as Bear Stearns and Lehman Brothers, both of which had severe financial problems, and said their problems severely damaged the financial system.
He also said that the shadow banking system played a far greater role than the subprime housing market in making the 2007-2009 economic crisis far more serious than the “dot-com” bust in 2000.
Bernanke made his comments at a conference on “Rethinking Finance” sponsored by the Russell Sage Foundation and The Century Foundation.
He said that the “insurance operations of AIG were supervised and regulated by various state and international insurance regulators, and the Office of Thrift Supervision had authority to supervise AIG as a thrift holding company.”
However, he said, “oversight of AIG Financial Products, which housed the derivatives activities that imposed major losses on the firm, was extremely limited in practice.”
The Fed was barred by a provision of the Gramm-Leach-Bliley Act of 1999 from overseeing insurance holding companies.
In his speech, he said “shadow banking” institutions that were unregulated or lightly regulated were typically not required to report data that would have adequately revealed their risk positions or practices.”
Moreover, he said, the lack of preexisting reporting and supervisory relationships hindered systematic gathering of information that might have helped policymakers in the early days of the crisis.
Bernanke said much of the decline in house prices had occurred since the most intense phase of the crisis; the decline in prices since September 2008 is probably better viewed as largely the result of, rather than a cause of, the crisis and ensuing recession
“More fundamentally, however, any theory of the crisis that ties its magnitude to the size of the housing bust must also explain why the fall of dot-com stock prices just a few years earlier, which destroyed as much or more paper wealth--more than $8 trillion--resulted in a relatively short and mild recession and no major financial instability,” Bernanke said.
He said that “shadow banking”, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.
Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies, Bernanke said.
And, he said, “Before the crisis, the shadow banking system had come to play a major role in global finance.”