My basic point is that a process of deleveraging, in which many financial intermediaries are simultaneously trying to shrink the size of their balance sheets, has produced a situation in which the quantity of credit available in the overall economy from a wide range of intermediaries has contracted sharply and suddenly—a credit crunch. Moreover, concerns about credit quality and solvency for intermediaries can devolve into liquidity problems, as in an old-fashioned bank run. Firms in the shadow banking sector are particularly vulnerable to this because, like banks, they typically issue short-term, highly liquid debt. The fear that an institution may be unable to meet its obligations to its creditors may trigger a withdrawal of credit—as in a bank run. Of course, the perceived inability of one institution to meet its obligations is likely to cast doubt on the ability of others to meet theirs, triggering chains of distress and systemic risk.

The Federal Reserve was created precisely to stem such systemic risks by acting as a lender of last resort, although not since the Great Depression has the Fed acted to accomplish it by lending directly through its discount window to an entity other than a depository institution. Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements, and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets,

Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of distress to other markets ...

The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings and rising unemployment.

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls...

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the Fed Funds rate.

If a central bank is to assume the responsibility of being a lender of last resort, it should clearly articulate its objectives in doing so. It should make credible that commitment and act in a way that is consistent with that commitment. It should clearly communicate its lending policies to the public. What’s more, the independence of the central bank’s decision making from short-term political interference is essential to sound policymaking in this arena as well.

There is no inherent conflict They do go together ... I don't think there is a fundamental trade-off. ... [But] while related, they need to be thought about separately.

As reported by Market News International, on whether there is a conflict between the Fed's monetary policy job and its role as lender of last resort, and on the relationship between monetary and policy and financial stability.

With regard to financial conditions more broadly, markets have not yet stabilized. Although financial instability originated in the residential mortgage-backed securities market, it has spread to affect a variety of credit markets via market linkages or institutional interdependencies. The experience has been traumatic, at times generating primal emotions. Market volatility has been driven by fear, distrust, and flight to safety. I emphasize this point because financial system stability is a central focus of Fed policy at the moment.

At the same time, inflation has become a more prominent concern.

The line that separates restoring market function from merely redistributing losses and gains is not a bright one. This is the reason that policymakers only rarely and reluctantly intervene in markets.

Also, the distinction between liquidity problems and insolvency is not a trivial one when monetary authorities respond to troubles of market players. The critical evaluation is the systemic risk posed by the failure of an institution.

Some believe the Fed has overreacted. Others have said the central bank has been slow to respond to building problems. And still others have warned that the Fed has crossed lines that define appropriate function.

But from where I stand, Fed actions were taken with a prudent acknowledgement of the unintended consequences that may accompany almost all policy interventions.

A week ago Sunday, the acquisition of Bear Stearns by JPMorgan Chase was announced. Earlier this week, the deal was changed from the original $2 per share to $10 per share, and certain specifics were adjusted. To facilitate this transaction, the New York Fed—through a limited liability company formed for this purpose—will take control of a portfolio of assets valued at $30 billion as of March 14. JPMorgan Chase will bear the first $1 billion of any realized losses in this portfolio, and any gains will accrue to the New York Fed. The arrangement was undertaken with the support of the U.S. Treasury.

This action was taken to bolster market liquidity and promote orderly functioning of short-term funding and credit risk markets.

[T]he ability of reductions in the federal funds rate to address liquidity strains in credit markets has proven to be limited.

A continuation of these liquidity strains presents a serious potential risk to the financial system. As a result, the Fed in recent months has undertaken additional steps to directly improve liquidity conditions in key credit markets.

Collectively, these innovations provide for much longer terms of lending, broader types of collateral, a wider class of counterparties, and a tighter spread between the primary credit rate and the target federal funds rate. All of these innovations are designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for promoting financial stability and economic growth.

The question is, do we need to have the same amount of information about their conditions.

From audience Q&A as reported by Market News International, referring to non-bank primary dealers now that they have access to Fed emergency lending facilities.

While governments cannot and should not uniformly avoid public support for creditors of failing banks, they should seek to minimize that support because of the distortions it produces. Such public support—even when it passes a benefit-cost test at the time of provision—encourages future risk-taking by institutions whose creditors expect to benefit from future support. Such risk-taking can even contribute to the specific financial conditions that prompt further government support. The key to addressing these costs is, when times are good, to act to reduce creditors’ expectations of receiving protection.

...

Policymakers should also undertake steps to better understand the potential for spillovers before large institutions get in trouble, as this would allow them to target any support they provide, or perhaps make it more likely that support could be avoided. Because I believe spillovers drive the provision of after-the-fact government support, I am not convinced that other approaches are as likely to alter creditors’ expectations.

Recent events have likely reaffirmed and strengthened some creditors’ expectations of support, or have created those expectations for the first time. I think one would be hard pressed to dismiss our analyses or proposals by claiming that such expectations do not exist. On the opposite end of the spectrum, some might dismiss our suggestions, arguing that we cannot influence creditors’ expectations. I reject that view as equally untenable. We simply cannot allow widespread perceptions of government support to pervade the financial system. Experience in other countries suggests that such a strategy is quite costly. And, in any case, our proposals seek to reduce systemic risk, an outcome presumably shared by policymakers regardless of their views on TBTF per se.

The potential for headwinds is integral to thinking about U.S. economic prospects over the next year or two. To the extent that headwinds gain momentum, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate.

The priority focus should be figuring out new ways to enhance liquidity, reduce the fear that people have as counter-party risk
...
We recently opened up our window to lend to what are called primary dealers. I fully expect that in return for that we will get regulatory authority to actually oversee those dealers, to make sure the people we're lending money to are adhering to the principles of good financial behavior.

As reported by Reuters