The Fed has worked hard for 30 years to develop credibility with the public that we will deliver on low and stable inflation. That credibility is hard to earn, but easy to lose if you’re not careful.

Clearly, the market discipline that “sophisticated investors” are supposed to provide was lacking.  As we saw, even some of the largest, most sophisticated financial institutions inadequately incorporated into their risk-management models the full range of hazards entailed in the originate-to-distribute business and the liquidity risks that would result from a drying up of short-term funding. Also lacking were reliable ratings from the agencies. But financial supervisors and regulators, including the Federal Reserve, were behind the curve, as well.  We missed some of the risky developments that were unfolding.  Our consumer regulations were unfortunately insufficient to protect households from some egregious and unfair lending practices. And we took too long to ramp up some supervisory policies in the face of mounting risks.

This is an important and extremely valuable time to be thinking on what is the best role for individual (financial) regulators; how can we best go forward and have the most effective regulatory system. 

I think certainly the supervision and regulation function that we (the Fed) have has been very important in providing us with the information and the expertise to be able to understand financial market developments and respond quickly both to individual institutions and more broadly to market developments.

From Q&A as reported by Market News International

Since the credit crisis began last August, the Fed has expanded the volume and types of loans it is willing to make to banks and securities dealers -- loans that are backed by a wide variety of collateral from subprime mortgages to student loans...

Mr. Volcker, testifying on responses to the credit crisis at the Joint Economic Committee of Congress Wednesday, said such activity "has not been the tradition of the central bank and I think that is an issue for the long run for the independence of the central bank. If it is going to be looked to as the rescuer or supporter of a particular section of the market, that is not strictly a monetary function in the way it's been interpreted in the past."

As reported by the Wall Street Journal

Gold is down, and I consider that to be a sign -- just one of a jillion, and I wouldn't overweight it -- that the marketplace considers the Fed serious about inflation -- not just me or somebody else -- but the Committee.

I used to think of monetary policy as dealing with generally normal periods interrupted by shocks. I’ve decided that it’s really the other way around. In fact, the Fed has had to face a whole series of shocks interrupted by occasional periods that we call “normal.” If you were to take the 10 years as a whole and divide it between periods of shocks or the threat of shocks vs. the “normal” periods, I think you’d find a lot more months in the first category.

One of the biggest innovations came in 1994 when the FOMC began to disclose what its policy decision was after each meeting. The communication since then, however, has sometimes been a bit muddled. I don’t think there is a settled view in the FOMC about the value of essentially forecasting policy, or trying to give hints about where you’re going to go. I’ve become skeptical of that approach because I think the correlation between where you go and where you can see yourself going in advance is very low. … I also think that there is unfinished business with regard to clarity of objectives. I’ve been an advocate since the first day I came here of a formal inflation target, and that issue is still unresolved. There is a huge amount of unfinished business in trying to define and communicate the Fed’s reaction function.

I would not expect the Federal Reserve Act to be opened and revised in any important respect in the absence of a significant monetary problem.  ... From time to time, there will probably be some attacks on us from Congress. That happens. But if we continue to perform pretty well on the macroeconomic front, I don’t think we’re going to be very vulnerable, and the attacks that occur from time to time will not have any material effect on the law. That means that the Federal Reserve banks will shrink in terms of their operating responsibilities. I think we need to get used to the prospect of Reserve banks being smaller in terms of employment, and more vigorous and more rigorous in terms of our intellectual output.

To start with, central bank credibility and low and stable inflation expectations are of critical importance. Earning that confidence is the most important thing the Fed can do in dealing with shocks as they occur. If the Fed doesn’t have that underlying confidence, then all sorts of things can go wrong and, indeed, the Fed may find itself willy-nilly taking policy actions intended to maintain or restore credibility rather than dealing with the current problem, whatever it might be. So, most of the work in dealing with the crises comes before they even happen. Where the Fed is now is a consequence of earning that credibility starting with Paul Volcker and then dealing successfully with a whole series of issues during the Volcker, Greenspan and now Bernanke eras.

The thing that I admire about Ben [Bernanke] is that right away – without a nanosecond’s time — he was thinking through these issues that I think should’ve been thought through before. But they weren’t; there were other priorities. The question is: what is the efficacy of further rate cuts?

In sum, the Federal Reserve has been acting on several fronts to address the recent turmoil in financial markets. Some of those actions are intended to stem the immediate problems. Others are intended to have longer-term benefits in helping to prevent future financial problems. But let me also add some words of caution about expecting more from the Fed than it has the ability to deliver. 

I think it is particularly important, for example, to recognize that monetary policy cannot solve all the problems the economy and financial system now face. It cannot solve the bad debt problems in the mortgage market. It cannot re-price the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies because some of their assets are now worth much less than previously thought. The markets will have to solve these problems, as indeed they will. But it will take some time. 

Unfortunately, the public perception of what monetary policy is capable of achieving seems to have risen considerably over the years. Indeed, there seems to be a view that monetary policy is the solution to most, if not all, economic ills. Not only is this not true, it is a dangerous misconception and runs the risk of setting up expectations that monetary policy can achieve objectives it cannot attain. To ensure the credibility of monetary policy, we should never ask monetary policy to do more than it can do.

The same could be said of the Fed’s lender of last resort function. All of the special lending facilities I described can be interpreted as part of that responsibility.  Traditionally, in times of financial crisis, a central bank is supposed to lend freely at a penalty rate against good collateral.  The experience of the past nine months suggests to me that we need to better understand how to apply this lender of last resort maxim in the context of today’s financial environment

Similarly, firms’ concerns about signaling have hampered the ability of the Federal Reserve to encourage borrowing from the Discount Window during times of stress. A particularly interesting example of this occurred last week with the latest auction conducted under the auspices of the Federal Reserve’s new Term Auction Facility (TAF).

The results of the latest TAF auction are shown on Figure 1. Allow me to provide a bit of background.

The TAF is an alternative to a Discount Window loan. Both result in a loan from the Federal Reserve to a financial institution, collateralized by assets that the borrowing institution has pledged to the Federal Reserve. However, with the addition of the TAF, financial institutions have two ways to borrow from the Discount Window. They can borrow using a traditional Discount Window loan, which is a loan at the primary credit rate – traditionally overnight but now up to 90 days term.2 Currently the primary credit rate is 25 basis points over the Federal Funds rate, or a rate of 2.5 percent. Alternatively, they can borrow for 28 days by participating in the Term Auction Facility, where the bidder is free to bid for funds at any rate above the minimum required for the auction (2.11 percent in the latest auction), and all those bids that are above the stop-out rate get the stop-out rate for the loan.

As can be seen in the graph, last week the stop-out rate was 2.82 percent, significantly higher than the primary credit rate of 2.5 percent. Such a bid could be explained if market participants believed it was likely that market rates would rise over the 28 day term, but evidence from trading in Federal Funds futures and in overnight index swaps indicate the opposite – that market participants believe it is far more likely that the Federal Funds rate will fall from its current target. Similarly, the TAF stop-out rate exceeds the one-month London Interbank Offered Rate (Libor), the rate at which banks can borrow one month unsecured money in London.
So how can this seeming anomaly be explained?

First, the Federal Reserve does not trade for profits in the markets, so the firms can bid in the auctions without fearing that their bids imply any immediate signaling of potential balance-sheet constraints or liquidity problems to the counterparty, the Federal Reserve. As a result, firms may be willing to pay a premium for transacting with the Federal Reserve in order to avoid any immediate public signaling, and to avoid taking actions that could potentially be construed as signaling the existence of problems.

Second, firms may want to be sure that they have some term funding, and by placing bids well above the primary credit rate they are in effect offering the equivalent of a non-competitive bid in a Treasury auction. They are willing to purchase the use of the term funds at whatever the current market clearing price is in the auction, even if there are less-costly options at the Discount Window or with private parties.

Third, the winners of TAF auctions are not disclosed by the Federal Reserve. Of course, neither are institutions that take out Discount Window loans disclosed by name. However, market participants may believe that the auction process, where a variety of 5 banks are jointly acquiring funds, may be interpreted differently than an individual institution borrowing from the Discount Window.

2 Discount Window loans are generally described as overnight loans, and had traditionally been. Due to actions taken by the Federal Reserve in response to market events, however, depository institutions can take Discount Window loans out for any term between overnight and up to 90 days. In August 2007 the Federal Reserve Board announced a change to allow the provision of term financing for as long as 30 days, renewable by the borrower. Then in March 2008 the Board approved an increase in the maximum maturity of primary credit loans to 90 days.

So, in essence a 28-day term Discount Window loan could be secured by a depository institution – a loan that would be similar to using the TAF’s structure, but at lower rate.

Also, it is worth highlighting that another structural difference between the TAF and the Discount Window is that a Discount Window loan can be prepaid at the option of the depository institution while the TAF cannot. This suggests that an institution with all other factors being equal, and absent consideration of any "stigma" or signaling issues, might use the Discount Window over the TAF.

3 By some accounts the reporting of Discount Window borrowing by Federal Reserve District is particularly concerning to a firm in a District which has few large participants – because any large borrowings from within such a District are likely to be done by only a limited pool of institutions, making market speculation more finely focused.

4 Recently, the financial press has reported on market speculation that Libor fixings are being under-reported.

From the footnotes

I believe this period of illiquid markets should also cause central banks to re-evaluate their roles. For a central bank to play an effective role during financial turmoil, it needs to understand the sources of liquidity problems, the interrelationships between market participants, likely losses, and market participants’ potential reactions to these losses

In my view, this can only be done if the central bank has some form of hands-on supervisory experience with institutions – particularly the "systemically important" institutions – regardless of who is the primary regulator. The Federal Reserve has been far more effective during this crisis because it has hands-on experience with bank holding companies that are among the most significant players in many financial markets.

In short, there are significant synergies between bank supervision and monetary policy during periods of financial turmoil – synergies that can be used to achieve better outcomes for the public as policy makers try to determine the impact of liquidity problems and how changes in credit will impact the broader economy

Having some form of similarly hands-on supervisory experience with any systemically important financial institution that may need to access the Discount Window is, in the long term, critically important. We need to understand the solvency and liquidity positions of firms that may access the Discount Window – with access, at the very least, to the information any counterparty would require in a lending relationship. For those financial institutions that do have access to the Discount Window, there is indeed a need for the Fed to have broader access to information than marketplace counterparty creditors, if we are to effectively manage our responsibilities as lender of last resort and custodian of financial stability. So, regardless of who is the primary regulator, it is important for the Fed to understand the consolidated capital and liquidity positions of such firms.

There is no way to put the genie back in the bottle ... Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done.

As reported by Bloomberg News