I do agree with these observers that the size of a financial institution is likely to be a useful source of information about the magnitude of that institution’s TBTF problem. At the same time, though, policymakers should guard against relying too much on this single metric. We should always keep in mind that the term too-big-to-fail is highly misleading. The TBTF problem is about creditor perceptions of loss protection. Creditors might well see the smaller of two institutions as being more likely to receive that protection, if the smaller institution is engaged in some kind of activity that is seen by government agencies as being especially vital. Thus, if we go back to 2008, government funds were used to facilitate the purchase of Bear Stearns by JP Morgan Chase. No such government funds were made available to facilitate the resolution of Lehman—and Lehman was certainly larger than Bear Stearns.

In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

...

Sixth, we could make structural changes to the financial system to make it more stable in terms of liquidity provision. For example, consider the three structural issues outlined earlier that amplified the crisis—tri-party repo, collateral requirements tied to credit ratings, and haircut spirals. In the case of tri-party repo, the amplifying dynamics could be reduced by enforcing standards that limited the scope of eligible collateral or required more conservative haircuts. Formal loss-sharing arrangements among tri-party repo borrowers, investors, and clearing banks might reduce or eliminate any advantage that might stem from running early. Eliminating the market’s reliance on intraday credit provided by clearing banks could eliminate the tension between the interests of clearing banks and investors when a dealer becomes troubled. In the case of collateral requirements, collateral haircuts could be required to be independent of ratings.

Many times in the last year I have expressed my astonishment that Congress was able to approve $700 billion in TARP funds in approximately one week and yet 18 months have passed since Bear Stearns was acquired by JPMorgan and there is still no resolution authority for the largest financial firms.

As I have noted, I believe that the Federal Reserve's actions to facilitate the acquisition of Bear Stearns, thereby preventing its bankruptcy and the disorderly liquidation of positions by its counterparties and creditors, were necessary and warranted to head off serious damage to the U.S. financial system and our economy. That said, the intended purpose of Federal Reserve lending is to provide liquidity to sound institutions. We used our lending powers to facilitate an acquisition of a failing institution only because no other tools were available to the Federal Reserve or any other government body for ensuring an orderly liquidation in a fragile market environment. As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.

The handling of Bear Stearns kept the institution open, preserved some shareholder value, and protected all other creditors. It also extended the federal safety net by providing discount window liquidity support and an express credit guarantee of $29 billion. In the case of Continental, the shareholders were eventually wiped out and the management was removed.

Should we view the extension as a one-time event or as permanent? In my view, it is almost impossible to go back. As Gary Stern has said, "There is no way to put the genie back in the bottle. Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done?"

For the United States, of course, perhaps the most difficult and important question involves access to central bank credit facilities by U.S. broker-dealers, including the primary dealers... Financial markets in most other countries are dominated by universal banks; in those circumstances, securities activities are carried out in organizations that have access to the discount window and other aspects of the safety net we associate with commercial banks...

We gave the primary dealers access to central bank credit under the unusual and exigent circumstances prevailing in mid-March. Their counterparties and creditors will presume that such access would again be granted if the health of the financial system is again threatened by loss of liquidity at the primary dealers. The public authorities need to consider several difficult issues with respect to access to the discount window. One is the circumstances under which broker-dealers should be permitted to borrow in the future...

The question has implications for the appropriate regulatory regime for broker-dealers and their parent companies. As I've already noted, the existence of liquidity facilities at the central bank can undermine normal incentives for maintaining liquidity buffers, and the more extensive the access, the greater the degree to which market discipline will be loosened and prudential regulation will need to be tightened...

In March, the storm was at its fiercest. Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

Since the credit crisis began last August, the Fed has expanded the volume and types of loans it is willing to make to banks and securities dealers -- loans that are backed by a wide variety of collateral from subprime mortgages to student loans...

Mr. Volcker, testifying on responses to the credit crisis at the Joint Economic Committee of Congress Wednesday, said such activity "has not been the tradition of the central bank and I think that is an issue for the long run for the independence of the central bank. If it is going to be looked to as the rescuer or supporter of a particular section of the market, that is not strictly a monetary function in the way it's been interpreted in the past."

As reported by the Wall Street Journal

Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets, with declining prices for asset-backed securities triggering margin calls, forced selling pushing prices down further, and mark-to-market losses triggering reductions in capital and escalating problems in other highly leveraged institutions.

By mid-March, however, the pressures in short-term financing markets intensified, and market participants were speculating about the financial condition of Bear Stearns, a prominent investment bank. On March 13, Bear advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated, and that it would be forced to file for bankruptcy the next day unless alternative sources of funds became available. A bankruptcy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued. In such circumstances, the Federal Reserve Board judged that it was appropriate to use its emergency lending authorities under the Federal Reserve Act to avoid a disorderly closure of Bear. Accordingly, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide short-term funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed the company's financial obligations. The Federal Reserve, again in close consultation with the Treasury Department, agreed to supply term funding, secured by $30 billion in Bear Stearns assets, to facilitate the purchase.

I do think that was a major step in providing credit to investment banks and primary dealers. Personally I don’t think there’s any going back from that. That’s not to say that the current facilities are going to be permanent or anything. But the precedent’s been set. I’ve written a lot and expressed a lot of concern about too big to fail and moral hazard and so forth. And I think those issues, once we get some of the current turmoil and strain behind us, I think some of those issues are going to require a very, very careful look….

One other important regulatory concern is that many of the steps public authorities have taken over the last year to stabilize the financial system seem likely to weaken market discipline and extend moral hazard problems to a much wider financial marketplace. A key example of this, the recent sale of Bear Stearns, seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out when larger financial institutions encounter problems. Bear Stearns’ collapse indicates that such phrases as “systemically important” and “too-big-to-fail” can even be applied to investment banks below the top tier.

The danger from a public policy perspective is that a much broader group of managers and creditors may now believe and act as if they have an added layer of protection from the risks they pursue. Beyond “too-big-to-fail” concerns, other market discipline and moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve had to take to provide liquidity to the market and expand discount window access.

To be sure, Bear Stearns’ equity holders—including many employees of the firm—took significant financial losses. This was an appropriate outcome. And doesn’t this action sufficiently curtail expectations of government support in the future and thus fix whatever problem such expectations create? The short answer is no.

There is no way to put the genie back in the bottle ... Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done.

As reported by Bloomberg News

The Fed has made some tough judgment calls lately, and, having been party to making those calls, I can assure you they certainly were not made lightly. In principle, we know that the market should decide the winners and losers, who survives and who fails. I am a big fan of Winston Churchill. “It is always more easy to discover and proclaim general principles than to apply them,” Churchill said. I now know full well what he meant.