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Tuesday, January 5, 2010

Financial Turmoil: Federal Reserve Policy Responses

The Federal Reserve (Fed) has been central in the policy response to the financial turmoil that began in August 2007. It has sharply increased reserves to the banking system through open market operations and lowered the federal funds rate and discount rate on several occasions. In December 2008, it formally shifted its primary focus away from targeting the federal funds rate, allowing it to fall close to zero. As the crisis deepened, the Fed’s focus shifted to providing liquidity directly to the financial system through new policy tools. Through new credit facilities, the Fed first expanded the scale of its lending to the banking system and then extended direct lending to non-bank financial firms. The latter marked the first time in over 50 years that financial institutions that are not member banks of the Federal Reserve System have been allowed to borrow directly from the Fed. After the crisis worsened in September 2008, the Fed began providing credit directly to markets for commercial paper and asset-backed securities. These programs resulted in an increase in the Fed’s balance sheet of $1.4 trillion at its peak in December 2008, staying relative steady since then. The Fed’s authority and capacity to lend is bound only by fears of the inflationary consequences, which have been partly offset by additional debt issuance by the Treasury. High inflation is unlikely to materialize as long as the crisis persists, but after the financial system stabilizes, the Fed may have to scale back its balance sheet rapidly to avoid it.

In March 2008, JPMorgan Chase agreed to acquire Bear Stearns. As part of the agreement, the Fed made a $28.82 billion loan to a limited liability corporation (LLC) it created to buy $29.97 billion of assets from Bear Stearns. The Fed has also agreed to make loans and purchase assets through an LLC from the American International Group (AIG) worth more than $120 billion. In November 2008, the Fed and federal government agreed to guarantee losses on $306 billion of assets owned by Citigroup. In all of these agreements, the Fed is exposed to downside financial risk if the assets purchased or guaranteed fall in value.
The statutory authority for most of the Fed’s recent actions is based on a clause in the Federal Reserve Act to be used in “unusual or exigent circumstances” that had not been invoked in more than 70 years. All loans are backed by collateral that reduces the risk of losses. Any losses borne by the Fed from its loans or asset purchases would reduce the profits it remits to the Treasury, making the effect on the federal budget similar to if the loans were made directly by Treasury. It is highly unlikely that losses would exceed its other profits and capital, and require revenues to be transferred to the Fed from the Treasury.

Two policy issues raised by the Fed’s actions are issues of systemic risk and moral hazard. Moral hazard refers to the phenomenon where actors take on more risk because they are protected. The Fed’s involvement in stabilizing Bear Stearns, AIG, and Citigroup stemmed from the fear of systemic risk (that the financial system as a whole would cease to function) if they were allowed to fail. In other words, the firms were seen as “too big (or too interconnected) to fail.” The Fed’s regulatory structure is intended to mitigate the moral hazard that stems from access to government protections. Yet Bear Stearns and AIG were not under the Fed’s regulatory oversight because they were not member banks in the Federal Reserve system.

The Helping Families Save Their Homes Act of 2009 (S. 896, P.L. 111-22) permits audits by the Government Accountability Office of limited Fed emergency activities. Other bills to audit the Fed include H.R. 1207/H.R. 3310/S. 604, H.R. 4173, S. 1803, and H.R. 2424/S. 1457. H.R. 4173 also modifies the Fed’s regulatory powers and emergency authority, and passed the House on December 11, 2009.

Date of Report: December 23, 2009
Number of Pages: 48
Order Number: RL34427
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