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Summary

The Federal Reserve (Fed) has been central in the response to the current 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. As the turmoil has progressed without signs of subsiding, the Fed has introduced new policy tools to try to restore normality. Through new credit facilities, the Fed first expanded lending to the banking system and then extended lending to non-bank financial firms. Lending to non-banks is a major departure from past policy, for it is the first time that financial institutions that are not member banks of the Federal Reserve System have been allowed to borrow directly from the Fed on a routine basis. As the crisis worsened, the Fed began providing credit directly to markets for commercial paper and asset-backed securities. As a result of these programs, the Fed?s outstanding loans and private asset purchases have ranged from $0.5 trillion to $1 trillion in recent months. The Fed?s authority and capacity to lend is bound only by fears of the inflationary consequences, which have been offset by additional debt issuance by the Treasury. 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 up to $112.5 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 of 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. The primary policy issues raised by the Fed?s actions are the 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 either 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 structure because they were not member banks.

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