One other important regulatory concern is that many of the steps public authorities have taken over the last year to stabilize the financial system seem likely to weaken market discipline and extend moral hazard problems to a much wider financial marketplace. A key example of this, the recent sale of Bear Stearns, seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out when larger financial institutions encounter problems. Bear Stearns’ collapse indicates that such phrases as “systemically important” and “too-big-to-fail” can even be applied to investment banks below the top tier.

The danger from a public policy perspective is that a much broader group of managers and creditors may now believe and act as if they have an added layer of protection from the risks they pursue. Beyond “too-big-to-fail” concerns, other market discipline and moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve had to take to provide liquidity to the market and expand discount window access.

Thus, as we take on these new challenges, I'll leave you with this quote from 1930 to illustrate my point. It is from Paul Warburg, who was appointed a member of the first Federal Reserve Board by President Woodrow Wilson.

"In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits are made and people are happy, is strongly resented. It is a desperately unpopular undertaking to dare to sound a discordant note of warning in an atmosphere of cheer, even though one might be able to forecast with certainty that the ice, on which the mad dance was going on, was bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice cracked, there would have been protests that the cover was strong enough and that no disaster would have occurred if only the situation had been left alone."1

There are many challenges ahead, many choices to make. Some I suspect will be desperately unpopular.

It is appalling where we are right now. [The Fed has introduced] a backstop for the entire financial system.

To be sure, Bear Stearns’ equity holders—including many employees of the firm—took significant financial losses. This was an appropriate outcome. And doesn’t this action sufficiently curtail expectations of government support in the future and thus fix whatever problem such expectations create? The short answer is no.

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

If I were to select a light-hearted title for my remarks, it might be “Fear and Loathing on Wall Street.” The basic premise is that as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded. The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish. As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm.

While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long.

The fact that banks are still choosing more costly financing options to avoid any potential signal of liquidity or balance-sheet constraints is very noteworthy – in that the financial turmoil that began in July of 2007 continues, even nine months after the onset of problems.

Unlike the credit crunch in the early 1990s in the United States, many financial firms have raised significant capital. Unfortunately, while in many cases these equity issues have offset recent losses, they may leave little additional buffer should further credit losses occur. A number of large financial institutions have reduced their dividends, and given the potential for additional capital shortages it goes without saying that financial institutions should continue to assess whether further reductions or cessation of dividends would be advisable.

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

No matter what the short-term benefits of that action were, or the other credit market interventions that we have undertaken, there is undoubtedly a risk of adverse incentive effects down the road and perhaps even in the near term as well.

From comments to press, as reported by Reuters

Last week in San Antonio, I provided my perspective on the situation we now encounter in a marketplace entering the early stages of recovery from a period of excess, indiscriminate behavior and historical (and occasionally hysterical) amnesia, and on the efforts we at the Federal Reserve are making to calmly and prudently restore the efficacy of the financial markets. I said then—and I assert again today—that there is nothing “unprecedented” about the situation we find ourselves in.

[The problems with LIBOR] do not hurt the efficacy of the liquidity programs put in place.

From Q&A as reported by Reuters

Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. ...

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

To protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. This is a necessary process, but it has been a difficult one as well; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. It is this tightening that is accentuating the downside risks for the economy as a whole. And in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run.