In advance of action as early as today from Sens. Warren and Vitter to curtail the FRB’s lender-of-last-resort powers, Karen Petrou’s memo last week focused on a startling statement from the Federal Reserve Bank of Richmond sure to empower those seeking to clip the central bank’s wings.  The Richmond research brief used a 1985 extension of then-unprecedented FRB support to the Bank of New York to argue that it essentially rescued a bank from an operational mess of its own making for which it—not the FRB—should have paid.  The paper then extrapolates that too much FRB liquidity support breeds this type of moral hazard.

Karen counters the Richmond example with the subsequent and also unprecedented FRB discount-window advances following the 9/11 attack.  The memo notes that some operational failures are not the fault of a big bank.  In the absence of the FRB’s backstop, systemic risk could well have resulted from the payment-system shut-down. 

Interestingly, as Karen’s memo notes, the Federal Reserve Bank of New York has taken a polar opposite stand from Richmond, laying out a new FRB role as market-maker of last resort.  This, Karen argues, would create massive moral hazard unless FRB backstops for non-banks were accompanied by prudential rules often wholly unsuited for the fund and asset managers seen by the FRB-NY as those who might come calling.

In short, she says, the FRB must set a clear emergency-liquidity policy in which it stipulates who might get what, how, and when.  If the “what” is more than typical discount-window advances to banks backed by quality collateral, then the FRB should be very hesitant to intervene.  It should also—and in advance—make this very clear to the financial market so that it contains moral hazard to the greatest extent possible.  As Karen’s memo says, if the FRB doesn’t make this clear, Congress might, and that would be worse.

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