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Summary

The Federal Reserve (Fed) has been intimately involved in the current financial turmoil since it 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 calm. In December 2007, it began to auction off reserves to member banks through the newly created Term Auction Facility (TAF). Equivalent in economic effect to the discount window, the TAF allows the Fed to control how much direct lending was undertaken and removes the stigma attached to the discount window that may have made member banks reluctant to access it. In March 2008, it created the Term Securities Lending Facility (TSLF) to expand its Treasury securities lending program. Under the new program, it allowed the primary dealers (financial institutions who are counterparties to the Fed in its open market operations) to temporarily swap their less liquid assets for Treasury securities. Later, it created the Primary Dealer Credit Facility (PDCF), which allowed it to temporarily lend to primary dealers directly. Unlike the TAF or TSLF, the PDCF is a major departure from past policy, for it is the first time that financial institutions that are not members of the Federal Reserve System (i.e., depository institutions) have been allowed to borrow directly from the Fed on a routine basis. On March 16, 2008, JP Morgan Chase agreed to acquire Bear Stearns. As part of the agreement, the Fed announced a $29 billion loan to a corporation it created to buy $30 billion of assets from Bear Stearns. In the event that the proceeds from the asset sales exceed $30 billion and the outstanding interest, the Fed will keep the profits. In the event that the loan principal and interest exceed the funds raised by the liquidation, the first $1 billion of losses would be borne by JP Morgan Chase, and any subsequent losses would be borne by the Fed. The statutory authority for the loan was 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. Loans through all programs are fully collateralized. Any losses borne by the Fed from the JP Morgan Chase loan or any of the new programs would reduce the profits it remits to the Treasury. It is highly unlikely that losses would exceed its profits and capital, and require revenues to be transferred from the Treasury. The primary policy issues raised by the Fed's response to financial turmoil 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 JP Morgan Chase's acquisition of Bear Stearns stemmed from the fear of systemic risk (that the financial system as a whole would cease to function) if Bear Stearns was allowed to fail. In other words, Bear Stearns was arguably 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 was not under the Fed's regulatory structure because it was not a member bank.

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