Note that it will not be sufficient simply to roll back the current lending programs when the economy recovers. The precedents that have been set during this episode will influence how market participants expect policymakers to react during the next episode of financial market turmoil. Establishing a coherent and stable financial regulatory regime will require rolling back expectations about how the policymakers will respond to the next financial market disturbance. Rolling back those expectations will be impossible if moral hazard concerns are always set aside in the exigencies of a crisis.⁴

 The problems of moral hazard and the existence of institutions that are "too big to fail" must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of "too big to fail" should be a top priority for lawmakers and regulators.

The striking feature of central bank lending 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.

[I]t will not be sufficient when the recovery comes, to scale back our lending," he warned, even though it will be necessary.   "Unless we do something valid," he went on to say, "the lingering expectation will be that when the next crisis comes, a similar response will be forthcoming."   Scaling back such an expectation, Lacker argued, is the challenge "of our time."

From the audience Q&A session, as reported by Market News

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.

...

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.

When we consider these consequences it becomes more apparent, to me at least, that we must strive to limit public safety nets and minimize their associated moral hazard problems… To return to my analogy, this means doubling back across the river to a more historical central banking role, and making clear a future crossing would be rare…

If we choose to double back, then we must also direct more supervisory focus to the market interdependencies among commercial banks, and we must institute better mechanisms to unwind failing nonbank financial institutions and their counterparty exposures.  

One day, a little Dutch boy was walking home when he noticed a small leak in a dike that protected the town. He started to stick his finger in the hole. But then he remembered the moral hazard lessons he had learned in school.  "Wait a minute," he thought.  “The companies that built this dike did a terrible job.  They don’t deserve a bailout, and doing so would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a flood plain.” So the boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned - including the little Dutch boy.

Perhaps you've heard the Fed's alternative version of the story.  In this kindler, gentler version, the little Dutch boy, somewhat desperate and worried about the horrors of a flood, stuck his finger in the dike and held it there until help arrived. It was painful and not guaranteed to work - and the little boy would rather have been doing other things. But he did it anyway. And all the foolish people who lived behind the dike were saved from the error of their ways.