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• U.S. Department of State

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. In December 2007, it began to auction off reserves to member banks through the newly created Term Auction Facility (TAF), which is equivalent in economic effect to the discount window, but in practice much larger. In March 2008, it created the Primary Dealer Credit Facility (PDCF), which allowed it to temporarily lend to primary dealers directly. Unlike the TAF, 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. As a result of these programs, the Fed's loans outstanding have exceeded $100 billion 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. On March 16, 2008, JPMorgan Chase agreed to acquire Bear Stearns. As part of the agreement, the Fed made a $28.82 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 $1.15 billion of losses would be borne by JPMorgan Chase, and any subsequent losses would be borne by the Fed. On September 16, 2008, the Fed announced it would lend the American International Group (AIG) up to $122.8 billion over the next two years. The statutory authority for loans to institutions that are not member banks 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 any of its new programs would reduce the profits it remits to the Treasury, making the effect on the federal budget similar to if the loans were made 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 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 stabilizing Bear Stearns and AIG 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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