Financial Markets

Today Chairman of the Federal Reserve Bank, Ben S. Bernanke, addressed the attendees of the Federal Reserve Bank of Atlanta Financial Markets Conference in Sea Island Georgia(via Satellite). His remarks suggest that the Bank of England has more flexibility than the Fed and thus can tailor better and more specific solutions to address the liquidity crisis. Specifically by repeatedly lowering the Fed Funds rate unlike the ECB, Bernanke has caused a major increase in prices across the board and is steadily stoking inflation and inlfation fears.

The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.

 The European Central Bank (ECB), for example, routinely conducts open market operations with a wide range of counterparties against a broad range of collateral. In recent months, in light of intense pressures in term funding markets, the ECB has provided relatively large quantities of reserves through longer-term open market operations. Extending this strategy, the ECB also introduced a new refinancing operation with a six-month maturity. The first of these was executed on April 2 and was well received. The Bank of England has followed a similar strategy, expanding their term open market operations and accepting a wider range of collateral. Very recently, the Bank of England also initiated a special liquidity facility that allows banks to swap high-quality mortgage-backed and other securities for U.K. Treasury bills.

Differences in legal and institutional structure have affected the methods used by various central banks to inject liquidity in their markets. In the United States, in ordinary circumstances only depository institutions have direct access to the discount window, and open market operations are conducted with just a small set of primary dealers against a narrow range of highly liquid collateral. In contrast, in jurisdictions with universal banking, the distinction between depository institutions and other types of financial institutions is much less relevant in defining access to central bank liquidity than is the case in the United States. Moreover, some central banks (such as the ECB) have greater flexibility than the Federal Reserve in the types of collateral they can accept in open market operations. As a result, some foreign central banks have been able to address the recent liquidity pressures within their existing frameworks without resorting to extraordinary measures. In contrast, the Federal Reserve has had to use methods it does not usually employ to address liquidity pressures across a number of markets and institutions. In effect, the Federal Reserve has had to innovate in large part to achieve what other central banks have been able to effect through existing tools.

 Much criticism came from the moral hazard issue :

The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.

Read the whole speech here.