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Blogging Bernanke

FED Chairman Ben Bernanke is the keynote speaker at the Federal Reserve Bank of Atlanta’s 2008 Financial Markets Conference. He’s speaking on the FED’s recent liquidity actions.

Central banks can help alleviate a crisis by lending secured by borrowers’ illiquid assets, thus allowing the borrower to avoid having to conduct a fire sale of those assets into illiquid markets. He notes that the ECB and Bank of England have expanded their open market activities and broadened the types of collateral they accept.

He notes that the FED historically has been more limited than some other central banks because only depository institutions have had access to the discount rate and the FED insisted on liquid collateral in open market operations, The FED therefore has had to jury rig (my words, not his) its processes to address the recent liquidity crisis.

The reluctance of depository institutions to use the discount window arises because banks fear that their counterparts will draw adverse inferences if discount window borrowing were to become known, The FED is trying to make discount window borrowing more attractive to depository institutions.

Under the Term Auction Facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized. Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). Bids will be submitted by phone through local Reserve Banks. The program has worked well to inject new liquidity into the markets.

Primary dealers were thought to be largely immune to runs on the bank. Once it became clear that financial markets could become so severely illiquid that even REPOs were threatened, the FED decided to make extend open market operations to include primary dealers.

In March, the Feeral Reserve used its emergency powers to extend credit to JP Morgan to buy Bear Stearns. It also set up the Primary Dealer Credit Facility, which is an overnight loan facility that will provide funding to primary dealers in exchange for a wide range of eligible collateral and is intended to foster the functioning of financial markets more generally.

Conditions in financial markets have improved somewhat. Once conditions return to normal, he expects that the FED will pull back as a lender of last resort. Instead, financial institutions will have to look to private sources of funding.

Bernanke turns to the moral hazard problem inherent in central bank interventions of the sort the FED has recently undertaken. He thinks the best solution is ex ante regulation and supervision to ensure that private financial institutions adopt strong liquidity risk management programs, the next crisis will be easier to manage.

The text of the speech is here.