The underlying causes of the persistence of relatively wide-term funding spreads are not yet clear.  Several factors probably have been contributing.  One may be potential counterparty risk while the ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined.  Another probably is balance sheet risk or capital risk--that is, caution about retaining greater control over the size of balance sheets and capital ratios given uncertainty about the ultimate demands for bank credit to meet liquidity backstop and other obligations.  Favoring overnight or very short-term loans to other depositories and limiting term loans give banks the flexibility to reduce one type of asset if others grow or to reduce the entire size of the balance sheet to maintain capital leverage ratios if losses unexpectedly subtract from capital.  Finally, banks may be worried about access to liquidity in turbulent markets.  Such a concern would lead to increased demands and reduced supplies of term funding, which would put upward pressure on rates.

My comments this morning are not intended to defend the regulatory and financial status quo, although I can understand that some may interpret them in that way. Rather, they are meant to suggest that there is likely little, if any, “low hanging fruit” to harvest and that, specifically, reforms may well impose inefficiencies and other costs of their own. The message is thus one of caution but not of inaction:  we should take considerable care in drawing conclusions about the origins of the recent bout of financial turbulence and about the implications for public policy.    

Well, first, Congresswoman, we're not bailing out anybody. We haven't put a penny of our money or federal money into these -- into the banks or into the CDOs.

What we are doing is exercising our responsibility to make sure that the banks disclose the information and that they value these things properly.

It's not our practice, in the broad financial world, to protect investors, particularly sophisticated investors, who should be able to make their own evaluations, from buying individual instruments.

What our responsibility is, is to make sure that the banks are safe and sound and that they are appropriately valuing their balance sheets and that their exposures to these off-balance sheet instruments are appropriately measured and accounted for, particularly with respect to capitals.

From the Q&A session

 But my reading of the evidence is that the episode was less about liquidity than it was simply about a dramatic change in the valuation of a class of credit exposures. Even with the Fed's reduction in the spread between its federal funds target and its primary credit discount window rates, and its encouragement to banks to come to the window, the amount of borrowing did not rise very much. So I think there's a good chance that, when all is said and done, we will be able to say that the Fed did the right thing. We stood ready to lend — on good collateral at a penalty rate — but did not interfere with the market's assessment of risks. 

As I mentioned earlier, one of the reasons that the price discovery mechanism has broken down in some U.S. markets in recent months is that a number of investors failed to exercise due diligence and relied on rating agency assessments.  That is, there was a lot of trust but not much verification.  I would suggest that the value of independent due diligence on the part of investors is especially high for newer and more-complex products compared with more traditional, familiar, and less-complex products.  

Importantly, the Federal Open Market Committee’s most recent action, the 50 basis point cut in the target federal funds rate in September, was an attempt to help offset the potential effects of financial market turmoil on real economic activity.  The breakdown in the price discovery process can, after all, have real economic consequences that the Federal Reserve should, in my opinion, consider when fulfilling its statutorily mandated goals of maximum employment and price stability.

I think we have to be ready for surprising developments in either direction. We have to be prepared to be nimble in either direction. Because it could be that all sorts of things would shake out relatively easily and comfortably and it could be that they won’t. I just don’t know.

In an interview with the Wall Street Journal

Between Aug. 10 and Aug. 24, the federal funds rate traded below the FOMC's target rate of 5.25 percent. Dudley said ``there was no stealth easing'' during that period, a reference to some economists' suggestions that the central bank wanted rates lower than it was willing to announce publicly during a credit crisis.

He said banks were anticipating an inter-meeting rate cut, so they were reluctant to bid the fed funds rate up to the target. Also, he said the Fed preferred to miss the target on the low side to avoid adding to market disruptions. 

 ``We definitely wanted to get back to target,'' he said, ``and it took a little bit longer than we wanted.''

As reported by Dow Jones Newswires

The U.S. subprime mortgage market is small relative to the enormous scale of global financial markets. So why was the impact of subprime developments on the markets apparently so large?  To some extent, the outsized effects of the subprime mortgage problems on financial markets may have reflected broader concerns that problems in the U.S. housing market might restrain overall economic growth. But the developments in subprime were perhaps more a trigger than a fundamental cause of the financial turmoil. The episode led investors to become more uncertain about valuations of a range of complex or opaque structured credit products, not just those backed by subprime mortgages. They also reacted to market developments by increasing their assessment of the risks associated with a number of assets and, to some degree, by reducing their willingness to take on risk more generally.

The Federal Reserve's actions to ease the liquidity strains in financial markets were similar to actions that central banks have taken many times in the past. Promoting financial stability and the orderly functioning of financial markets is a key function of central banks. Indeed, a principal motivation for the founding of the Federal Reserve nearly a century ago was the expectation that it would reduce the incidence of financial crises by providing liquidity as needed.

In its supervisory role, the Federal Reserve--like other bank regulators--attempts to ensure that individual banks maintain adequate liquidity on hand and make provision to raise additional funds quickly when the need arises. We must be wary of a subtle fallacy of composition, however. Even if each market participant holds a significant reserve of what--in normal times, at least--would be considered highly liquid assets, for the system as a whole the only truly liquid assets are cash and its equivalents. The quantity of cash assets in the system at a point in time is, in turn, essentially fixed, being determined directly or indirectly by the central bank.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

I nevertheless considered the larger-than-usual cut in the funds rate prudent because of two features of the current environment. First, the stance of monetary policy before the September meeting was probably a bit on the restrictive side, at least according to many estimates of the so-called “neutral” or “equilibrium” federal funds rate. In fact, the stance of policy was growing more restrictive as core inflation gradually trended down. Second, with the economy operating near potential and inflation well contained, a case could have been made that the funds rate would need to move down toward a neutral stance, even if there had not been a financial shock.

Most notably, investors' concerns about exposures to subprime mortgage credit risk caused them to shun commercial paper that might be backed by such assets, in both Europe and the United States.  This aversion, in turn, meant that commercial banks that had written backup liquidity lines for commercial paper programs or had other connections with these programs might have to make good on their actual or implied support by extending credit.  With leveraged buyout credit and some mortgage originations also possibly staying on the balance sheet unexpectedly, the banks faced substantial, but uncertain, calls on their liquidity and capital.  All this uncertainty led the banks and other short-term lenders to turn very cautious; interest rates on bank deposits and other sources of credit beyond just a few days rose steeply, funding in money markets became concentrated in the very short term, and concerned and uncertain lenders generally became much less willing to extend the credit needed for liquid and efficient financial markets. 

Our policy easing was aimed at helping to offset the effects of those tighter credit conditions and thereby to encourage moderate economic growth over time.  It was not intended to, nor should it, short circuit a more realistic pricing of risk and the gains and losses that the repricing will entail for market participants.