Recently, we have watched the deterioration in financial conditions extend beyond the subprime market.  Investors appear to have reassessed their outlook and their tolerance for risk, especially for structured financial products and for securities of highly leveraged firms.  Bond spreads--especially those for speculative-grade debt--widened substantially in June and July, and the volatility of equity prices increased as well.  In mid-August, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets, including short-term and interbank funding markets, became increasingly impaired.  Notably, many asset-backed commercial paper programs found rolling over their paper increasingly difficult.  To help restore orderly conditions, the Federal Reserve in recent weeks has increased the provision of reserves, cut the discount rate, and changed its usual discount-window lending practices in order to facilitate term borrowing, together with other measures. 

A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth. Certainly, standing here today, it is obvious that tighter credit conditions and disruptions in financial markets have increased the uncertainty surrounding our forecasts of the economy. The FOMC continues to monitor incoming data and other economic information for signs that these disruptions are having a broader impact on the economy. In my view, it will be very important to assess such information in light of the Fed’s commitment to achieving its long-run goals of price stability and sustainable economic growth.

Since 2003 the discount rate on primary credit has been above the Fed’s target for the federal funds rate. Reserve Banks lend freely at this higher rate to healthy banks that pledge acceptable collateral, basically on a “no-questions-asked” basis. Virtually all assets held by banks are eligible for use as collateral. What’s more, banks are not required to exhaust alternative sources of funds before coming to the discount window, and banks can request a discount window loan at any time of the day. In addition – and very importantly at times of financial market stress – banks are able to relend the funds to other banks or to other parties.

The Federal Reserve was largely created to act as a lender of last resort, and central banks have often provided liquidity in times of large-scale financial stress. I think this is the appropriate response to financial market turmoil, but in any given case there are still questions of how much to intervene, and for how long. How those questions are answered can have longer-term consequences for inflation expectations.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified. I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital.

[T]he Fed has unique powers to provide liquidity to the financial system, through means that include open-market purchases, discount-window loans, and intra-day overdrafts. 

As I’ve emphasized before, the Federal Reserve does not have the legal authority to bail out a troubled GSE. The Fed can provide liquidity support through its discount window, but only indirectly through collateralized loans to banks that would then bear the credit risk of making loans to a troubled firm.  Under emergency conditions, the Fed does have the authority to make loans directly to a GSE, but the loans must be fully collateralized. The Fed is obviously disinclined to use its emergency powers to lend to firms other than banks; despite numerous financial upsets over the years, the Fed has not used this authority since the 1930s.

A very interesting case arose with the terrorist attacks on 9/11. Thinking back to my academic years before coming to St. Louis, I recall no discussion or journal articles analyzing the possibility that the payments system might crash because of physical destruction. But that is what nearly happened, because the Bank of New York, a major clearing bank, was disabled when the twin towers came down. Moreover, trading closed in the U.S. Treasury and equity markets, and banks were unable to transfer funds because the Bank of New York was not functioning. With normal sources of liquidity shut down, many banks faced the prospect of being unable to meet their obligations. The Fed’s provision of funds through the discount window and in other ways prevented a cascading of defaults around the world. No private entity would have been able to provide liquidity on such a massive scale.

...I believe the markets do have confidence that the Fed has necessary legal authority and the internal strength to act as necessary. That said, the Fed’s reluctance to act is also an important element of strength.

I have always been a great defender of the proposition that the Federal Reserve should be the leading regulator and supervisor of banks. There are other agencies involved, but when push comes to shove because of lenders' last resort position, in other words, Federal Reserve has a special responsibility and once you control the banking system, that was enough and the rest of the market ought to go on its own.

 Well, that was fine when commercial banks were 60% or 70% of the financial system and we're a long, long ways from that and in fact, what we still call the big commercial banks, aren't commercial banks anymore. That's kind of a subsidiary operation and they all want to become investment managers and investment banks and insurance companies and all sorts of things. Which really raises the question of whether the - what we have in law is the traditional supervisory distribution of authority, is really relevant.

The relation of central bank credit to the broader public safety net has implications that are sometimes overlooked. For example, the collateralization of central bank credit extension may reduce risks to the central bank, but it can increase risk to the deposit insurance fund. Therefore, the central bank ought to consider more than just its own balance sheet risk in making lending decisions. This is especially important because, as the lender of last resort, the central bank can often force an institution’s closure by refusing credit.

Derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles’ heel. The benefits of risk dispersion are accomplished without holding massive positions in the underlying financial instruments. Yet, too often in our financially checkered past, the access to such leverage has induced speculative excesses that have led to financial grief. We are scarcely likely to reform the underlying human traits that lead to excess, but we do need to buttress our risk management capabilities as best we can to delimit such detours from the path of balanced growth.

More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort.

Thus, the question emerges; can the Federal Reserve respond to "financial crises" in the same way that it responded to "banking crises" in the past?

My own view is that the Federal Reserve now has less flexibility in responding to crises as this relates to its operation of the discount window. Historically, the discount window has been the Federal Reserve’s principal facility for providing liquidity in times of crisis. Indeed, going back to the 1980s and early 1990s, the Federal Reserve provided extensive lending through its extended credit program to banks experiencing prolonged liquidity problems. Going forward, however, the discount window is less likely to be used for several reasons.

First, use of the window is now circumscribed by the provisions of FDICIA designed to minimize FDIC exposure if the Federal Reserve lends to institutions that ultimately fail. Second, banks have become reluctant to use the window in normal times and so may not be willing to approach the window in difficult times for fear of signaling changes in their condition. Third, to the extent that crises now originate outside the banking system, nonbank institutions do not have direct access to the discount window to meet their liquidity needs.

In short, creditors probably considered the prospects for Fed assistance {to NBW} to be uncertain. Maybe the Fed would lend; maybe it would not.

Some observers might view this uncertainty positively as 'constructive ambiguity.' In their view, because a troubled bank’s uninsured depositors and other uninsured creditors are not certain Fed assistance will be forthcoming, they have reason to monitor bank risk-taking.

But if these depositors and creditors are unsure about the prospects for Fed lending, the implication is that they see at least some chance of assistance, which would reduce the incentive to monitor risk. This might just as reasonably be called 'destructive ambiguity.' Beyond its impact on uninsured creditor behavior, such ambiguity may expose the Fed to political pressure in problem bank situations, since it implies the lack of a firm and consistent rule on procedure when these situations arise. Indeed, ambiguity may invite creditors who stand to lose money to try to bring political pressure to bear on the Fed.