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Tuesday, July 27, 2010

Financial Turmoil: Federal Reserve Policy Responses

Marc Labonte
Specialist in Macroeconomic Policy

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. Since December 2008, it has allowed the federal funds rate 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 since the Great Depression that firms that are not banks or members 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. All of these emergency facilities had expired by the end of June 2010, but central bank liquidity swap lines were reopened in May 2010 in response to the crisis in Greece. The Fed also provided emergency assistance to Bear Stearns, AIG, and Citigroup over the course of the crisis; the Fed still holds assets from and loans to AIG and assets from Bear Stearns.

These programs resulted in an increase in the Fed's balance sheet of $1.4 trillion at its peak in December 2008, staying relatively 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 has not materialized yet because most of the liquidity created by the Fed is being held by banks as excess reserves, but after the economy stabilizes, the Fed may have to scale back its balance sheet rapidly to avoid it. Asset sales could be disruptive, but the Fed has argued that it can contain inflationary pressures through the payment of interest on bank reserves, which it was authorized by Congress to do in 2008.

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." 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 income 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 income and capital, and require revenues to be transferred to the Fed from the Treasury. To date, the Fed's crisis activities have increased its net income.

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 regulates member banks 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.

Some Members of Congress have expressed concern that certain details of the Fed's lending activities are kept confidential. H.R. 4173 adds conditions to the Fed's emergency lending authority, removes most GAO audit restrictions, and requires disclosure of the identities of borrowers with a delay. It also changes the Fed's role in the financial regulatory system (see CRS Report R40877, Financial Regulatory Reform: Systemic Risk and the Federal Reserve).

Date of Report: June 15, 2010
Number of Pages: 56
Order Number: RL34427
Price: $29.95

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