EconSouth (Second Quarter 2008)

Research Notes and News

Research Notes and News highlights recently published research as well as other news from the Federal Reserve Bank of Atlanta.

Bernanke explains Fed's recent liquidity measures
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.

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 hrough the Fed's discount window for fear that market participants would think it signifies financial weakness.

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.

But if a central bank is too quick to provide liquidity in a crisis, it could induce moral hazard—the incentive for market participants to take more risks if they believe the Fed will come to the rescue. Bernanke believes this problem can perhaps be best 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."
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Atlanta Fed conference examines reforms
Academics, policymakers, and market practitioners gathered in May to discuss the status and future of financial market reforms at the Atlanta Fed's annual Financial Markets Conference at Sea Island, Ga.

Topics explored included Sarbanes-Oxley corporate governance requirements; investor activism; Regulation FD, which aims to level the informational playing field among institutional investors, analysts, and individual investors; and the likelihood of a global, round-the-clock capital market emerging.

Regarding Sarbanes-Oxley, the consensus from the gathering was that research conducted thus far has yielded mixed results in terms of the law's effects on companies and investors. The discussions also pointed out the reality that market forces are continually evolving in response to regulation, innovation, and other events or phenomena. For example, the rapid advance of technology has eroded the traditional monopoly power of financial exchanges such as the New York Stock Exchange. Today, almost anyone can trade virtually any financial instrument from almost anywhere, giving rise to a complex array of trading platforms, joint ventures, and alliances among market participants that are extremely difficult to regulate.
Financial Markets Conference papers and presentations

Lockhart: Too soon to breathe easy
Atlanta Fed President Dennis Lockhart said in a June 2 speech that the last few weeks in the economy have had the feel of "coming up for air," though he cautioned that it is too early to "breathe easy."

The national economy has faced continual challenges since the emergence and spread of financial turmoil beginning last August, Lockhart noted. Among those challenges, he listed financial market illiquidity and significant losses by banks and financial institutions, a home building slowdown and falling house prices, the rapid onset of general economic weakness, and inflation pressures stemming partly from rising energy prices.

Lockhart characterized the current economy as "growing slowly, poised for gradual recovery, but carrying real risks that could subvert the story."

Looking forward, Lockhart expects forthcoming information to reveal a weak first half of 2008 followed by some improvement in the second half as the challenges he listed gradually diminish. Nevertheless, he said, the nation's economic outlook remains uncertain mainly because of three main risks: renewed financial instability, an oil price shock, and a long and even steeper decline in house prices.

In addition to those immediate concerns, Lockhart discussed "persistent structural imbalances that present serious risks to our nation's long-term and continuing economic well-being," including structural trade deficits, foreign petroleum dependency, and fiscal deficits. "These concerns deserve high rank on the country's economic agenda," he said.
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