Financial Update (Second Quarter 2008)

Fed Chair Explains Fed's Recent Liquidity Measures

Fed Chairman Ben Bernanke In a speech delivered via satellite to the Atlanta Fed Financial Markets Conference in May, Federal Reserve Chairman Ben Bernanke explained the principles behind central bank action to support market liquidity and the reasoning behind the Fed's actions to soothe recent strains in short-term funding markets.

Bernanke outlined the Fed's thinking in responding to a sharp increase in the demand for cash or equivalents by private creditors by providing new liquidity instruments to commercial banks and investment banks.

He cited research establishing that a central bank may be able to eliminate or limit negative outcomes by making cash loans secured by borrowers' illiquid but sound assets. "Thus, borrowers can avoid selling securities into an illiquid market, and the potential for economic damage ? is substantially reduced," Bernanke said.

New tools for new times
In recent months it became clear, he noted, that the discount window—part of the Fed's traditional framework for providing market liquidity—had become less effective in addressing the strains in short-term funding markets. Banks had become reluctant to borrow through the Fed's discount window for fear that market participants would think it signifies financial weakness.

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Thus, last December the Fed introduced the Term Auction Facility, through which discount window credit is auctioned every two weeks to eligible borrowers for terms of 28 days. This process, Bernanke noted, appears to have overcome the "stigma problem" of the discount window: Large numbers of banks have participated in each auction held so far, and the size of each auction has been increased from $20 billion at the start to $75 billion in the May auctions.

Best approach is preventing overly risky behavior
But if a central bank is too quick to provide liquidity in a crisis, moral hazard—the incentive for market participants to take more risks if they believe the Fed will come to the rescue—could result. Bernanke believes this problem might best be addressed by supervision and regulation that ensure financial institutions manage liquidity risks effectively before a crisis.

"Of course, even the most carefully crafted regulations cannot ensure that liquidity crises will not happen again," Bernanke concluded. "But if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced."


June 25, 2008