The striking feature of central bank lending and other government financial support during the recent turmoil is the extent to which it has extended well beyond the boundaries that previously were understood to constrain such lending, both in the range of institutions and the contractual terms on which credit has been provided. Intervention has been driven by a desire to prevent damaging disruptions to financial markets, and thus reduce the overall costs of the turmoil. While this objective is clearly understandable, central bank lending can create the expectation that similar support will be forthcoming when market disruptions occur in the future. Such expectations can themselves be very costly, because they can distort the incentives faced by, and as a result, the choices made by private-sector participants. For example, in the past year, expectation of official support may have induced some firms to take the risk of turning down capital infusions or merger offers in hopes of finding better terms in the future. Prospective equity investors may have demanded stiffer terms to compensate for the possibility of dilutive government intervention.

Since the onset of the crisis, the Fed has massively expanded the provision of liquidity to financial institutions, thereby easing the broader credit crunch. Serving as lender of last resort is a time-honored function for central banks and is critical in mitigating systemic risk. But in doing so during the current crisis, the Fed has crossed traditional boundaries by extending the maturity of the loans, the range of acceptable collateral, and the range of eligible borrowing institutions. At the onset of the crisis, the Fed encouraged banks to use the discount window. The apparent stigma associated with use of the window, however, discouraged banks from borrowing. To address this problem, the Fed introduced and has substantially expanded a new auction system (the Term Auction Facility or TAF) to distribute discount window loans.

Discussions of the role of the central bank as a lender of last resort often appeal to Walter Bagehot’s classic prescription: “Lend freely at a high rate, on good collateral.”⁶ But Bagehot’s teachings are not directly relevant to modern central bank lending. Lending by modern interest-rate-targeting central banks is by necessity sterilized. By itself, a central bank loan increases both the liabilities and assets of the central bank. The additional reserves would tend to drive the interest rate below the target, so central banks generally sterilize their lending operations via offsetting asset sales.⁷ In Bagehot’s time, however, unsterilized lending was the only way for the central bank to prevent a spike in interest rates by elastically increasing the supply of central bank money when the demand for it rose in a crisis. In other words, Bagehot’s dictum was about monetary policy — that is, the size of the central bank’s balance sheet — not credit policy, which alters just the composition of a central bank’s asset holdings.

The Federal Reserve responded to these developments in two broad ways. First, following classic tenets of central banking, the Fed has provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-term funding markets. Second, to reduce the downside risks to growth emanating from the tightening of credit, the Fed, in a series of moves that began last September, has significantly lowered its target for the federal funds rate.

Our preference is to allow market forces to handle any required restructuring in the financial services industry. However, in some cases this is not possible when the risks to financial stability are too high.

Regardless of our intentions, we need to recognize that by taking these actions, we create expectations about future interventions and who will have access to central bank lending. These expectations, in turn, can create moral hazard by influencing firms' risk management incentives and the types of financial contracts they write, which may ultimately increase the probability and severity of future financial crises.

Going forward, just as we should avoid setting unrealistic expectations for monetary policy, we should also avoid encouraging unrealistic expectations about what the Fed can do to combat financial instability. As I have argued, in times of financial crisis, a central bank should act as the lender of last resort by lending freely at a penalty rate against good collateral. Yet, recent experience suggests we need to clarify what the Fed can and cannot be expected to do in today's complex financial environment.

The events of the past year underscore the importance of carefully assessing the current financial regulatory structure. Regulatory reforms should aim to lower the chances of financial crisis in the first place, for example, by setting capital and liquidity standards that encourage firms to appropriately manage risk. We should consider market structures, clearing mechanisms, and resolution procedures that will reduce the systemic fallout from failures of financial firms. Indeed, it would be desirable to be in an environment where no firm was too big, or too interconnected, to fail.

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I believe that the central bank should clearly state objectives and set boundaries for its lending that it can credibly commit to follow. Clarifying the criteria on which the central bank will intervene in markets or extend its credit facilities is not only essential but critical.

As investors and creditors lost confidence in the ability of certain firms to meet their obligations, their access to capital markets as well as to short-term funding markets became increasingly impaired and their stock prices fell sharply. Among the companies that experienced this dynamic most forcefully were the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac; the investment bank Lehman Brothers; and the insurance company American International Group (AIG).

The Federal Reserve believes that, whenever possible, such difficulties should be addressed through private-sector arrangements--for example, by raising new equity capital, as many firms have done, by negotiations leading to a merger or acquisition, or by an orderly wind-down. Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk. In those cases when financial stability is threatened, however, intervention to protect the public interest may well be justified.

{Constructive ambiguity} is a phrase that's been used often in central banking circles. And I think it's most often associated with the idea that you should hold back communicating what circumstances under which you're willing to lend or intervene, and allow market participants to be uncertain about what those circumstances are. I think that the objective of, the argument I've heard for constructive ambiguity amounts to having two things at once. Having the discretion to intervene, but trying to convince markets that you won't.
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If you intervene, it's going to involve some moral hazard. Moral hazard's going to be the greater the greater the probability people expect you to intervene. So you'd like to minimize moral hazard. So you'd like them to think you're not going to intervene. At the same time, when the time comes, and some crisis emerges, you would like to have the discretion to intervene. So I think of constructive ambiguity as an attempt to have it both ways, to try and get people to behave as if you're not going to intervene, but to retain the discretion to intervene.

I want to identify some issues that are critical to our current responsibilities and will be important in defining an appropriate role in the future, with the most effective mix of responsibility and authority.
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First, the Fed has a very important role today, working in cooperation with bank supervisors and the SEC, in establishing the capital and other prudential safeguards that are applied on a consolidated basis to the institutions that are critical to the proper functioning of financial markets.
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Second, the Fed, as the financial system’s lender of last resort, should play an important role in the consolidated supervision of those institutions that have access to central bank liquidity and play a critical role in market functioning.
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Third, the Federal Reserve should be granted explicit responsibility and clear authority over systemically important payment and settlement systems, and the ability to continue to encourage broader improvements in the over-the-counter derivatives markets.
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Fourth, the Federal Reserve Board should have an important consultative role in judgments about official intervention where there is potential for systemic risk, as is currently the case for bank resolutions under FDICIA.
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And, finally, the responsibilities for market and financial stability that are accorded the Fed in current and any future legislation will require that the Fed adopt a more comprehensive approach to financial supervision and market oversight.
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These initiatives will take time, but we expect to see substantial progress over the next two quarters.

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.

Broadly speaking, we believe that primary dealers are strengthening liquidity and capital positions to better protect themselves against extreme events. We also believe their management has learned some valuable lessons from the events of the recent financial turmoil that should translate into better risk management. We continue to monitor the effect of the PDCF and are studying a range of options going forward.

The major central banks should put in place a standing network of currency swaps, collateral policies and account arrangements that would make it easier to mobilize liquidity across borders quickly in crisis. We have some of the elements of this framework in place today, and these arrangements have worked relatively well in the present crises. We should leave them in place, refine them further and test them frequently.

I do believe, however, that lender-of-last resort policies should take a lesson from what we have learned from the theory of monetary policy. In particular, policy should have important rule-like features. Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step. But policy must also make credible commitments to act in a systematic way consistent with explicit ex-ante guidelines. Discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk. Nevertheless, the issue of trading off financial stability and moral hazard will likely remain. 

The dramatic recent expansion in Federal Reserve lending raises the possibility that market participants view future access to Fed credit as having been substantially broadened. For evidence, market participants could point to the fact that entities formerly viewed as unlikely to have access to the discount window, such as the primary dealer subsidiaries of investment banks, have now been granted access...In my view, there is value in communicating policy intentions clearly. Deliberate imprecision — the so-called "constructive ambiguity" approach — leaves it to market participants to draw inferences for future policy from our past actions. Without an articulated statement of intention regarding lending policy, the time consistency problem is likely to be a difficult challenge because it will be hard to resist the future temptation to mitigate financial market stresses when they arise.

Beyond that, the central bank's historical role as a lender of last resort places it squarely in the center of financial disruptions as they unfold. We are perhaps not as close to a consensus on the proper conduct of this role as we are with regard to price stability. But as we continue to learn about the causes and nature of financial instability, I believe we should strive for policy that is informed by the lessons learned in the achievement of price stability. Chief among those is that a central bank can achieve better outcomes if it can establish credibility for a pattern of behavior consistent with achieving its long-term goals.

In particular, the public authorities must address a difficult yet very important question: To what degree should entities with access to central bank credit be permitted to rely on that access to meet potential liquidity demands? Central bank liquidity facilities are intended to permit those with access to hold smaller liquidity buffers, which allows them to fund more longer-term assets and thereby promotes capital formation and economic growth. At the same time, however, the existence of central bank credit facilities can so undermine incentives for maintaining liquidity buffers that institutions hold more longer-term assets than is socially desirable and thereby pose excessive risk to themselves and the financial system.