Normally, most central banks supply and absorb reserves primarily in the safest and most liquid parts of the money markets.  In these segments of the markets they can operate in size without distorting prices, and without preferential treatment for certain private borrowers or forms of collateral. The private sector then distributes the reserves around the markets--across counterparties, maturities, and degrees of creditworthiness. The resulting transactions enhance market liquidity and allow private market participants to allocate credit and determine the appropriate compensation for taking risk.

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets. In fact, several of the Federal Reserve's new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted but to make participation uneconomic when markets are functioning well. Under current law, our facilities for investment banks that don't involve securities eligible for open market operations (OMO-eligible paper) will necessarily be wound down when circumstances are no longer "unusual and exigent"; I'll come back to questions about these facilities in a minute.

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose. They have been successful at reducing the stigma that can impede borrowing at the discount window in a crisis environment and might be very useful in dealing with future episodes of illiquidity in money markets. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order. The latter might require that we allow the auction to set the price without a constraining minimum, but a small auction should not distort the allocation decisions of private participants.

Our experience in recent months has underlined the global interdependencies of financial markets. Globally active banks manage their positions on an integrated basis around the world, and pressures originating in one market are quickly transmitted elsewhere. Central banks should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed. That approach will require the consideration of arrangements with sound institutions in which central banks would accept foreign collateral denominated in foreign currencies. Those arrangements are under active study and a number of issues need to be resolved. It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks.

Another instrument of liquidity provision that central banks are examining is currency swaps to facilitate granting liquidity in other currencies. The central banks found currency swaps useful because the impediments to intermediation in money markets naturally extended to transactions across currencies as well as across maturities and counterparties...

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...

[T]he Fed can reduce bank funding risks by providing a safe harbor for financing less liquid collateral on bank and primary dealer balance sheets. Reducing this risk may prove helpful by lessening the risk that an inability to obtain funding would force the involuntary liquidation of assets. The ability to obtain funding from the Fed reduces the risk of a return to the dangerous dynamic of higher haircuts, lower prices, forced liquidations, and still higher haircuts that was evident in March.

So how are these facilities supposed to work? What’s the theory? The notion is that the auction facilities should be the main means by which the Fed provides liquidity support to depository institutions and primary dealers. The PCF and PDCF are standby facilities designed to provide reassurance to market participants that sound depository institutions and primary dealers have access to backstop sources of liquidity. But the actual amount of funds advanced through these facilities is likely to be limited in most circumstances.

The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort. This helps to reassure the two triparty repo clearing banks and the triparty repo investors that the primary dealers will be able to obtain funding. This bolsters confidence in the triparty repo system and reduces the risk of the type of funding run that led to Bear Stearns’ illiquidity crisis.

The auction facilities have several advantages relative to the backstop facilities. First, they are dynamic—the results shift from auction to auction. The information obtained through the auction process facilities price discovery and helps policymakers assess market conditions and sentiment. Second, the auctions appear to have less stigma than the backstop facilities. Stigma is the word used to describe the unwillingness to use a liquidity facility because of fears that such use could send an adverse signal about the health and viability of the borrower.

For the auction facilities, stigma is very low for several reasons. First, many participants participate in the auctions. This provides cover against the potential for an adverse signal from participation. Second, the auctions are conducted for settlement on a forward basis. For example, in the TAF auction, the bidding takes place on Monday and settlement on Thursday. This time lag makes it clear that participants are not bidding because they need immediate funds and are having serious liquidity problems.

So how have the facilities performed in practice? As designed, most of the dollars have been disbursed via the auction facilities, the FX swaps, and the single-tranche OMOs, rather than via the backstop facilities.

And what are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest" (p. 99). Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets.³ Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.

In sum, the Federal Reserve has been acting on several fronts to address the recent turmoil in financial markets. Some of those actions are intended to stem the immediate problems. Others are intended to have longer-term benefits in helping to prevent future financial problems. But let me also add some words of caution about expecting more from the Fed than it has the ability to deliver. 

I think it is particularly important, for example, to recognize that monetary policy cannot solve all the problems the economy and financial system now face. It cannot solve the bad debt problems in the mortgage market. It cannot re-price the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies because some of their assets are now worth much less than previously thought. The markets will have to solve these problems, as indeed they will. But it will take some time. 

Unfortunately, the public perception of what monetary policy is capable of achieving seems to have risen considerably over the years. Indeed, there seems to be a view that monetary policy is the solution to most, if not all, economic ills. Not only is this not true, it is a dangerous misconception and runs the risk of setting up expectations that monetary policy can achieve objectives it cannot attain. To ensure the credibility of monetary policy, we should never ask monetary policy to do more than it can do.

The same could be said of the Fed’s lender of last resort function. All of the special lending facilities I described can be interpreted as part of that responsibility.  Traditionally, in times of financial crisis, a central bank is supposed to lend freely at a penalty rate against good collateral.  The experience of the past nine months suggests to me that we need to better understand how to apply this lender of last resort maxim in the context of today’s financial environment

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

I believe this period of illiquid markets should also cause central banks to re-evaluate their roles. For a central bank to play an effective role during financial turmoil, it needs to understand the sources of liquidity problems, the interrelationships between market participants, likely losses, and market participants’ potential reactions to these losses

In my view, this can only be done if the central bank has some form of hands-on supervisory experience with institutions – particularly the "systemically important" institutions – regardless of who is the primary regulator. The Federal Reserve has been far more effective during this crisis because it has hands-on experience with bank holding companies that are among the most significant players in many financial markets.

In short, there are significant synergies between bank supervision and monetary policy during periods of financial turmoil – synergies that can be used to achieve better outcomes for the public as policy makers try to determine the impact of liquidity problems and how changes in credit will impact the broader economy

Having some form of similarly hands-on supervisory experience with any systemically important financial institution that may need to access the Discount Window is, in the long term, critically important. We need to understand the solvency and liquidity positions of firms that may access the Discount Window – with access, at the very least, to the information any counterparty would require in a lending relationship. For those financial institutions that do have access to the Discount Window, there is indeed a need for the Fed to have broader access to information than marketplace counterparty creditors, if we are to effectively manage our responsibilities as lender of last resort and custodian of financial stability. So, regardless of who is the primary regulator, it is important for the Fed to understand the consolidated capital and liquidity positions of such firms.

So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired.

With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.³ Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline.

...

Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.

As reported by Bloomberg News

What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return.

...

The extension of lending directly to non-banking financial institutions -- while under the authority of nominally `temporary' emergency powers -- will surely be interpreted as an implied promise of similar action in times of future turmoil.

As reported by Bloomberg News

Simply stated, the bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the marketplace. To meet the challenge, the Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long embedded central banking principles and practices.

They {Bear Stearns} may have had adequate regulatory capital, but their problem was more liquidity than capital. What happened was that there were certainly market concerns about their positions, and confidence began to erode and they began to lose their funding.

     We were not informed of the imminence of the situation until about 24 hours before the event -- probably on Thursday with the announcement of their information that they were going to be likely in default on Friday morning. And it was at that time that we began our emergency response.

     More normally, we would have had more warning and we have had more time to develop a more effective response.

     Going forward, we continue to monitor financial institutions. We hope to improve the liquidity situation by extending liquidity to investment banks, dealers, as well as to depository institutions.

From the Q&A session.