Protecting against economic shocks

The Baltimore Sun

Federal Reserve Chairman Ben S. Bernanke rightly believes that "it is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

The Fed should, however, take reasonable precautions against economic shocks that can seriously damage the economy.

When the Federal Reserve meets again tomorrow, it is likely to announce another interest rate cut to mitigate the subprime mortgage crisis. But it must also consider longer-term solutions posed by the systemic risk to the domestic and global markets. An economic shock, such as a market panic or institutional failure, could trigger a domino effect, causing the failure of a chain of markets or institutions that ultimately affects the real economy.

Our views of such systemic risks have been hampered by the historical focus of many economists on banks rather than on financial markets such as stock and bond exchanges. However, as more companies access financial market funding without going through banks, greater focus must be devoted to markets.

This is why the Fed's current approach, which focuses exclusively on monetary policy, is insufficient.

Last month, the Federal Reserve responded to the subprime mortgage crisis by cutting the discount rate, the interest rate the Fed charges banks. This approach helps banks but does not directly affect financial markets - and it is markets, not banks, that are at risk in the current crisis.

Changes in monetary policy also don't often work quickly enough, or are too weak, to quell panics, falling prices and systemic collapse.

The Federal Reserve must think more broadly. Monetary policy should not be discarded, but it must be supplemented. The problem of systemic risk requires a governmental solution because individual participants in the market do not have incentives to limit risk-taking in order to reduce the danger to other participants and third parties.

One idea is to create a lender of last resort to prop up failing financial institutions and markets to avoid serious harm to the public. A lender of last resort could, for example, purchase securities in failing markets, thereby stabilizing values. To mitigate "moral hazard" - the tendency of people protected from the consequences of risky behavior to engage in such behavior - the lender of last resort should have the right, but not the obligation, to intervene, and the rules by which funds are provided should not be transparent to the public.

A lender of last resort need not burden taxpayers. If established as a government entity, the lender of last resort could finance itself either by charging premiums to market participants - similar to the approach taken by the Federal Deposit Insurance Corp. when insuring deposit accounts - or by charging market-rate interest on loans or taking market discounts on purchases.

Because finance and markets are globally interconnected, systemic collapse in one country inevitably will affect markets and institutions in other countries. A lender of last resort therefore might appropriately be a multinational entity. Or the function could be privatized.

All things considered, however, the Federal Reserve is the most logical entity in the United States to play the role of lender of last resort, at least domestically.

The Fed may need to obtain additional legal authority to do so, but this should not be difficult to accomplish.

Some may think that in the current subprime crisis, the Federal Reserve already has been acting as a de facto lender of last resort by making, as touted in the media, "liquidity injections." But that liquidity only indirectly benefits the financial markets actually driving the crisis.

The Fed may not be responsible for protecting individuals and institutions from the consequences of their actions, but it is responsible for protecting the rest of us from the risk of a systemic collapse of our increasingly interconnected financial system.

Steven L. Schwarcz is the Stanley A. Star professor of law and business at Duke University and founding director of the Duke Global Capital Markets Center. His e-mail is

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