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The financial crisis that began in 2007 was triggered by over-leveraged homeowners and a severe downturn in US housing markets. However, a reasonably well-supervised financial system would have been much more resilient to this and other types of severe shocks. Instead, the core of the financial system became a key channel of propagation and magnification of losses suffered in the housing market. Critical financial intermediaries failed, or were bailed out, or dramatically reduced their provision of liquidity and credit to the economy. In short, the core financial system ceased to perform its intended functions for the real economy at a reasonable level of effectiveness. As a result, the impact of the housing-market shock on the rest of the economy was much larger than necessary. In this essay, I will review the key sources of fragility in the core financial system. I discuss the weakly supervised balance sheets of the largest banks and investment banks; the run-prone designs and weak regulation of the markets for securities financing and over-the-counter derivatives; the undue reliance of regulators on market discipline; and the interplay of too-big-to-fail and the failure of market discipline. Finally, I point to some significant positive strides that have been made since the crisis: improvements in the capitalization of the largest financial institutions, a reduction of unsafe practices and infrastructure in the markets for securities financing and derivatives, and a significantly reduced presumption that the largest financial firms will be bailed out by taxpayer money in the future. But I will also mention some remaining challenges to financial stability that could be addressed with better regulation and market infrastructure.

The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.

Dealer banks--that is, large banks that deal in securities and derivatives, such as J. P. Morgan and Goldman Sachs--are of a size and complexity that sharply distinguish them from typical commercial banks. When they fail, as we saw in the global financial crisis, they pose significant risks to our financial system and the world economy.How Big Banks Fail and What to Do about Itexamines how these banks collapse and how we can prevent the need to bail them out. In sharp, clinical detail, Darrell Duffie walks readers step-by-step through the mechanics of large-bank failures. He identifies where the cracks first appear when a dealer bank is weakened by severe trading losses, and demonstrates how the bank's relationships with its customers and business partners abruptly change when its solvency is threatened. As others seek to reduce their exposure to the dealer bank, the bank is forced to signal its strength by using up its slim stock of remaining liquid capital. Duffie shows how the key mechanisms in a dealer bank's collapse--such as Lehman Brothers' failure in 2008--derive from special institutional frameworks and regulations that influence the flight of short-term secured creditors, hedge-fund clients, derivatives counterparties, and most devastatingly, the loss of clearing and settlement services. How Big Banks Fail and What to Do about Itreveals why today's regulatory and institutional frameworks for mitigating large-bank failures don't address the special risks to our financial system that are posed by dealer banks, and outlines the improvements in regulations and market institutions that are needed to address these systemic risks.

I describe asset price dynamics caused by the slow movement of investment capital to trading opportunities. The pattern of price responses to supply or demand shocks typically involves a sharp reaction to the shock and a subsequent and more extended reversal. The amplitude of the immediate price impact and the pattern of the subsequent recovery can reflect institutional impediments to immediate trade, such as search costs for trading counterparties or time to raise capital by intermediaries. I discuss special impediments to capital formation during the recent financial crisis that caused asset price distortions, which subsided afterward. After presenting examples of price reactions to supply shocks in normal market settings, I offer a simple illustrative model of price dynamics associated with slow-moving capital due to the presence of inattentive investors.

This is a survey of progress with the postcrisis global (G20) reform of the financial system, in five key areas of new regulation: (1) making financial institutions more resilient; (2) ending “too-big-to-fail”; (3) making derivatives markets safer; (4) transforming shadow banking; and (5) improving trade competition and market transparency. The resiliency reforms, particularly bank capital regulations, have been increasingly successful in improving financial stability, but have been accompanied by some reduction in secondary-market liquidity. I review specific areas where reforms are far from complete, or have even been counterproductive. This paper was accepted by Gustavo Manso, finance. Conflict of Interest Statement: The author's webpage at http://www.stanford.edu/~duffie/ provides related research and disclosure of potential conflicts of interest.

Weaknesses in the design of the market for US Treasuries have reduced the effectiveness of world's favored safe-haven asset. Since the Global Financial Crisis, the market's intermediation capacity is far more constrained by the balance sheets of dealer banks, which handle virtually all investor trades. Since 2007, the total size of primary dealer balance sheets per dollar of Treasuries outstanding has shrunk by a factor of four. This trend continues because of large US fiscal deficits and post-GFC regulatory capital constraints, which are necessary for financial stability but limit the provision of liquidity under stress. For US Treasuries to remain a powerful safe haven, the intermediation capacity of the market will need to be expanded and further supported by official-sector backstops.

We test the doubly stochastic assumption under which firms' default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or \"frailty\" (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time-series properties of default intensities. The data do not support the joint hypothesis of well-specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities.

This article provides the causes and symptoms of special repo rates in a competitive market for repurchase agreements. A repo rate is, in effect, an interest rate on loans collateralized by a specific instrument. A \"special\" is a repo rate significantly below prevailing market riskless interest rates. This article shows that specials can occur when those owning the collateral are inhibited, whether from legal or institutional requirements or from frictional costs, from supplying collateral into repurchase agreements. Specialness increases the equilibrium price for the underlying instrument by the present value of savings in borrowing costs associated with the repo specials.

In the setting of \"affine\" jump-diffusion state processes, this paper provides an analytical treatment of a class of transforms, including various Laplace and Fourier transforms as special cases, that allow an analytical treatment of a range of valuation and econometric problems. Example applications include fixed-income pricing models, with a role for intensity-based models of default, as well as a wide range of option-pricing applications. An illustrative example examines the implications of stochastic volatility and jumps for option valuation. This example highlights the impact on option 'smirks' of the joint distribution of jumps in volatility and jumps in the underlying asset price, through both jump amplitude as well as jump timing.

We model a simple market setting in which fragmentation of trade of the same asset across multiple exchanges improves allocative efficiency. Fragmentation reduces the inhibiting effect of price-impact avoidance on order submission. Although fragmentation reduces market depth on each exchange, it also isolates cross-exchange price impacts, leading to more aggressive overall order submission and better rebalancing of unwanted positions across traders. Fragmentation also has implications for the extent to which prices reveal traders’ private information. While a given exchange price is less informative in more fragmented markets, all exchange prices taken together are more informative.