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Some Thoughts On The Fed and Bank Bailouts

The US Federal Reserve has been forced to open its books to reveal to whom it lent trillions of dollars and against what collateral. The Huffington Post has a few good articles out today on the Fed’s lending during the height of the credit crisis. Let me make a few comments on the lending, before I send you off to these articles.

In my view, the Federal Reserve is as much a political organisation as it is a financial organisation. The real power behind the Fed rests with the Federal Reserve Board and the New York Fed in Washington D.C. and New York City respectively, owing to its dual financial and political roles.  The Board of the New York Fed, which is responsible for most of the Fed’s market-making and crisis-preventing activity, is comprised of the very bankers which control America’s private sector financial resources. This puts the Fed in an untenable position, the outgrowth of which is regulatory capture by the financial services sector.

My view is that the Fed’s role should be circumscribed. Nevertheless, the Fed serves an important function in the US and global economy in providing liquidity, as we have witnessed during the crisis. It is the American โ€“ and in many respects, the global โ€“ lender of last resort.  Walter Bagehot wrote an eponymous financial book in the 19th century called Lombard Street, giving advice on finance and banking. The most important and quoted piece of advice Bagehot  gave was to the Central Bank, in this case the Bank of England. He told them to "lend freely at a high rate, on good collateral."

This is something the Federal Reserve has failed to do during the credit crisis. The Fed lent freely, but at a low rate, on dodgy collateral.  This was true even before Lehman collapsed. See the Wall Street Journal’s "Bye, Bye Bagehot" article on Fed lending under the Term Auction Facility from January 2008 for example. The setup of the Fed’s Primary Dealer Credit Facility had the clearing banks determine the haircuts banks had to take for taking loans from the Fed. The result has been an inability of market participants, regulators or the wider public to differentiate between the truly insolvent companies and the illiquid. The resulting lack of confidence in the entire financial system and by financial institutions in each other has been damaging to the global economy.

This is the crux of the Fed’s problem โ€“ and its conduct during the crisis is emblematic of the untenable role of the institution as both regulator and servant of the financial services industry.

Keep this in mind as you read Shahien Nasiripour’s article "Fed Opens Books, Revealing European Megabanks Were Biggest Beneficiaries". I also recommend reading the Huffington Post’s live blogging ode to the Fed’s revelations at "Federal Reserve Documents: LIVE Updates ".

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.