Fed’s steps to aid banking system raise risks, too

The Federal Reserve’s bold steps to prevent the banking industry from collapsing last year have injected new dangers into the financial system.
Analysts and government officials fear that the nation’s biggest banks will be emboldened to resume excessive risk-taking on the belief that the Fed will be there – again – to prevent them from collapsing.
They also worry that the Fed’s unilateral actions during last year’s crisis could come back to haunt it – by jeopardizing its political independence. The Fed’s freedom from politics is critical to its ability to do what’s right for the long-term health of the economy, even if that means taking action that causes short-term pain, such as raising interest rates.
To fight the recession and financial crisis, Fed Chairman Ben Bernanke unleashed some of the most aggressive actions in the history of the central bank, which was created in 1913 after a series of bank panics.
He slashed interest rates to record lows near zero. He provided low-cost loans for banks and – for the first time in the Fed’s history – bought debt so companies would have short-term “commercial paper” loans available to pay for salaries and supplies. The Fed also bought mortgage-backed securities and government bonds to drive down interest rates on mortgages and other consumer debt.
For much of the Fed’s nearly 100-year history, it was reluctant to meddle deeply in financial crises, especially to save individual firms. In 1998, Fed Chairman Alan Greenspan and his colleagues engineered a private bailout of a hedge fund, Long-Term Capital Management, out of fear its collapse would endanger the economy. But no money from the Fed or the government was used.
The financial turmoil that erupted last year forced the Fed to rethink its precedents. A student of the Great Depression throughout his academic career, Bernanke grasped when the credit markets froze last fall that to revive lending and stabilize banks he needed to quickly pump trillions of dollars into the financial system.
Economists believe future Feds will be similarly interventionist during major crises, with a broader view of the central bank’s role as the ultimate backstop for banks, providing them with loans when they can’t get money anywhere else.
“They changed forever what the Fed does in a crisis,” says Alice Rivlin, who served as the Fed’s No. 2 official in the late 1990s. “The next time we have a major, or perhaps a minor, crisis, people will expect the Fed to take much more aggressive action than they expected this time.”
The problem is that the bold actions the Fed took over the past year can, paradoxically, encourage the very types of high-risk bets by Wall Street firms that can feed speculative bubbles – and possibly another financial crisis.
On Monday – the first anniversary of Lehman Brothers’ collapse – President Barack Obama warned Wall Street against returning to the sort of reckless behavior that threatened the nation with a second Great Depression And he warned financial executives that they could not count on any more bailouts.
Still, a precedent has been set whereby the government will come to the banks’ rescue if their investment mistakes turn out to be colossal enough to potentially drag down the entire financial system. The risk is that this creates a “moral hazard” on Wall Street.
Unless Congress creates a mechanism to safely wind down big financial companies whose collapse could threaten the economy, the Fed might be forced again next time to help bail out individual firms. Bear Stearns, American International Group Inc., Citigroup and Bank of America were among companies that gained help in the past year from either the Fed or Treasury.
“Moral hazard has to be a concern for anyone involved with financial policy,” says Lawrence Summers, director of the White House National Economic Council.
Another concern is maintaining the Fed’s independence to set monetary policy without political interference. Lawmakers who believe the Fed overreached last year – by essentially printing money to save troubled banks – could try to exert more influence over the agency down the road.
Already, efforts are gaining on Capitol Hill for congressional investigators to audit Fed decisions on interest rates, which influence economic growth, employment and inflation. Economists fear the Fed could succumb to political pressure by Congress or the president to keep interest rates low for too long.
Through the Fed’s history, such fights have waxed and waned. The last big battle fought was by former Fed Chairman Paul Volcker. He caused a deep recession when he jacked up interest rates to end 1970s “stagflation,” a toxic mix of stagnant economic activity and inflation.
Bernanke will be under intense political pressure when it comes time to rein in the emergency lending programs and to start boosting interest rates – necessary moves to avoid unleashing a dangerous bout of inflation.
Bernanke – and his successors – will also be expected to intervene more quickly to prevent speculative asset bubbles. This was made clear by the widespread damage caused by the housing bust, which ignited the global financial crisis.
House prices tanked and foreclosures surged. Financial institutions holding soured mortgages suffered hundreds of billions in losses. Problems spread from high-risk to more creditworthy borrowers. Eventually, a range of loan categories – from business to auto loans, home equity credit lines and short-term corporate lending – froze up.
To deflate the next bubble early, the Fed could push up interest rates to slow down economic growth. And to limit the chances of another bubble forming in the first place, the Fed could boost the amount of capital that financial companies need to hold to offset potential losses. This effectively minimizes how much they can bet.
Any effort by the Fed to prevent asset bubbles would illustrate just how much the central bank has changed since the current crisis erupted. When Wall Street banks and investors are making money on their gambles, those on the winning side don’t want to see the Fed pull the plug. Politicians don’t, either.
For years, the consensus at the Fed has been that central bankers’ role is to stabilize the financial system after speculative bubbles burst – not try to prevent them in the first place.
“It’s hard to see how these precedents won’t last for a while,” says John Taylor, a Treasury official in the Bush administration, an expert on Fed policy and now a Stanford economics professor. “The Fed’s interventions will be more active than in the past.”
As Congress revamps financial regulations, the Obama administration wants the Fed to regulate financial giants whose demise could endanger the entire economy. It also wants the Fed to police the financial system for excessive risks. Doing so could push the Fed even deeper into Americans’ economic lives – by influencing what financial products and services are available and at what prices.
But the Fed also could lose powers if it is stripped of its consumer oversight protections as envisioned by the Obama administration. Because of the Fed’s failure to head off the financial crisis, some in Congress prefer to see those duties spread among the Fed and other regulators.
After a mostly hands-off stance during Alan Greenspan’s 18-year tenure at the Fed, the Bernanke Fed responded to congressional and public outrage and cracked down on shady mortgages and abusive credit card practices. Many of the dubious mortgages Greenspan had refused to clamp down on were eventually blamed for contributing to the housing boom and its bust.
Whatever happens, the Fed – whether forced by Congress or not – will have to become more open about its actions. And by explaining its new financial tools to the public and investors, the Fed might be able to increase their effectiveness.
“Bernanke is beginning to allow some much-needed sunshine into the mausoleum,” says Kenneth Thomas, a lecturer in finance at the University of Pennsylvania’s Wharton School. “I think it will persist even after Bernanke is gone. There’s a sense the doors of the temple need to be thrown open.”

Related Topics: Banking, Commentary/opinion, Federal Reserve