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.

A widespread shortfall in liquidity could cause assets to trade at prices that do not reflect these fundamental valuations, impairing the ability of the market mechanism to efficiently allocate capital and risk. Furthermore, reduced availability of credit could reduce both business investment and the purchases of consumer durables and housing by creditworthy households.

We clearly must be vigilant about these risks to economic growth. However, overly accommodative liquidity provision could endanger price stability, which is the second component of the dual mandate. After all, inflation is a monetary phenomenon. Indeed, one of the many reasons for the Fed's commitment to low and stable inflation is that inflation itself can destabilize financial markets.

[W]e certainly cannot rule out the possibility of continued market difficulties. We cannot be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios and restructuring their balance sheets accordingly. Moreover, further mortgage defaults due to declines in house prices and the fact that many sub-prime adjustable rate mortgages will see their rates rise over the next few months could have negative feedbacks onto housing and financial markets. Furthermore, there remains a good deal of uncertainty about the creditworthiness of many key market participants.

The current turmoil in financial markets has led to a tightening of credit that has affected the broader economy and has the potential to continue to restrain economic growth going forward. The risk that the financial turmoil could become more severe and further adversely affect the functioning of financial markets suggests to some that short-term interest rates need to be lower than they would be otherwise in order to provide a form of insurance. However, determining the appropriate extent of such extra accommodation is difficult to quantify.

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.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

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