Fed officials worry that central bank went too far in crisis


Posted at Jun 06 2008 10:20 PM | Updated as of Jun 07 2008 06:20 AM

Agence France-Presse

WASHINGTON - The US Federal Reserve's expanded lending to banks and investment firms to stem a credit crisis may end up creating more instability, two Fed officials said Thursday.

Philadelphia Fed president Charles Plosser and his Richmond counterpart, Jeffrey Lacker, in separate speeches expressed concern that the central bank's actions since the crisis began nine months ago could produce a so-called "moral hazard" by encouraging risk taking.

The comments highlighted deep rifts at the Fed, which has been aggressively moving to pump liquditity into strained financial markets and took the unusual step of backing a rescue of troubled investment giant Bear Stearns in March.

The efforts to stabilize markets can "actually make instability more severe in the long run," said Plosser, a voting member of the policy-setting Federal Open Market Committee.

The Fed or any other central bank faces the risk of creating more instability any time it intervenes as lender-of-last-resort to financial firms, Plosser told the Society for Financial Econometrics in New York.

Specifically, if lending to major financial institutions is "misapplied," it can "effectively subsidize risk-taking by systemically important financial institutions," he said.

Lacker, an alternate FOMC member, delivered a blunt warning to an economics conference in London.

"The danger is that the effect of recent credit extension on the incentives of financial market participants might induce greater risk taking, which in turn could give rise to more frequent crises, in which case it might be difficult to further resist expanding the scope of central bank lending."

While the financial meltdown that hit investment bank Bear Stearns and the freezing up of markets for asset-backed securities have been compared to old-fashioned runs on a bank, Lacker said it was important to distinguish what he calls fundamental financial motivations from simple mob psychology.

"My reading of recent financial market events suggests to me that fundamentals have been at work -- given the large shortfall in mortgage returns confronting the financial sector, the resulting strains should not be surprising," he said.

In March, the Fed engineered a controversial rescue of Bear Stearns as the investment bank teetered on collapse due to mortgage-related losses from the worst housing crisis in decades.

Fed chairman Ben Bernanke defends the move as critical to the health of the financial system.

"With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence," Bernanke said in April testimony to Congress.

Plosser said that the new environment and the "opacity of the so-called shadow banking system" was making it more difficult for central bankers to distinguish fundamental repricing from simple panic.

"It is less clear how to distinguish disruptions in the efficient functioning of financial markets that call for central bank intervention from necessary market corrections to asset prices," Plosser said.

Plosser and Lacker said that there need to be firm rules established for deciding when the Fed would intervene to smooth out markets.

In Plosser's view, "discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk."

If they are allowed to expect similar aid in the future, Lacker said, "banks do not self-protect and thus leave themselves more susceptible to runs."

"The only credible way to limit expectations of future lending is to incur the risk of short-run disruptions to financial markets by disappointing expectations and by not lending as freely as before," Lacker said.