WASHINGTON — Congress is likely to spend much of the next year or two debating whether and how to create a systemic risk regulator to oversee all large financial institutions.
But 2008 is likely to go down in history as the year the Federal Reserve Board assumed that role on its own.
The financial crisis has forced the central bank to take extraordinary steps, from backstopping Citigroup Inc. and American International Group Inc. — though it had no oversight of the latter — to hastily creating programs to support everything from corporate debt to money market mutual funds.
But the Fed's rapid expansion of responsibility has also left it facing a daunting array of challenges: a balance sheet that has more than doubled in the past year, a series of hastily arranged programs that must eventually be unwound, billions in increasingly questionable collateral, and concerns about its independence.
"The biggest thing the Fed has done has been becoming something other than the Fed," said Adam Schneider, a principal at Deloitte Consulting LLP. "It's dangerous, to be candid. Sure, it will be positive in the short term because we don't want something like an AIG to become a Lehman Brothers and become disruptive. But once you exit the banking system, I don't know what you're entering. I don't know what the limits are."
Others say that, in its reach for more authority, the Fed stands to lose its status as one of the most independent institutions in Washington. During the financial crisis, the Fed has often appeared — at least in public — to take cues from Treasury Secretary Henry Paulson in rescuing various institutions and setting up programs.
"They have sacrificed a great deal of independence," said Allan Meltzer, a professor at Carnegie Mellon University and a noted Fed historian. "There is a reason we separate central banks and make them independent. … We don't want the administration to be in charge of the printing press."
Even some Fed insiders have become leery of its tactics. Gary Stern, the president of the Federal Reserve Bank of Minneapolis, has repeatedly argued that the central bank's rescues have reinforced the notion that some institutions are "too big to fail."
A look at its balance sheet shows how much has changed at the Fed in the past year. Once a sleep-inducing weekly report, the Fed's balance sheet has grown nearly 150%, to $2.3 trillion. In addition to its traditional discount window operations, lending to financial institutions, the Fed runs at least nine new programs.
With another program to buy asset-backed securities scheduled to begin in February, and commitments to buy mortgage-backed securities issued by the government-sponsored enterprises, the balance sheet could easily top $3 trillion in 2009.
As it struggles with the deteriorating financial sector, the Fed made clear in a policy statement last week that its balance sheet will not be a limitation.
"The Fed will continue to consider ways of using its balance sheet to further support credit markets and economic activity," it said in the Dec. 16 statement.
Banks will be crucial to helping the Fed fund future rescues and backstops. With financial support from the Treasury Department dwindling, the Fed is increasingly reliant on bank reserves to fund its operations.
It began paying interest on bank reserves in September, and the response has been dramatic. At $801.7 billion on Dec. 17, reserves held at the Fed were 20 times more than on Jan. 2.
But as the Fed continues to expand, concerns surround the central bank's use of its balance sheet and the level of risk it might be taking on.
For one, it has steadily broadened the scope of collateral it will accept beyond the highest-quality assets to include mortgages and other loans. The Fed takes undisclosed haircuts, and if an asset's rating slides below investment grade, it can no longer be used as collateral against a loan from the discount window.
But it has not detailed what kind of collateral it holds or how its value has changed.
"The risk profile has dramatically increased," Deloitte's Mr. Schneider said. "It's been a choice, not an accident. They've chosen to expand collateral from just Treasury bills."
Brian Gardner, an analyst at KBW Inc.'s Keefe, Bruyette and Woods Inc., said that, since the Fed has not disclosed its holdings, it is safe to assume some bad assets are on its books.
"It indicates the Fed has stuff on there that it doesn't want to talk about," he said. "Clearly, there are probably some risky assets on the books right now, and that presents challenges for the Fed."
One of the few losses the Fed has disclosed is a $2 billion decline reported in October on $29 billion of assets the central bank is holding from Bear Stearns. But Fed officials continue to defend the liberalization of their collateral policy.
"I realize that, by straying from our usual business of holding plain-vanilla Treasuries as assets and by shifting policies away from simple iterations of the fed funds rate, we have raised a few eyebrows," Richard Fischer, the president of the Federal Reserve Bank of Dallas, said in a speech last week. "But these are complex, trying times. Our economy faces a tough road. We are the nation's central bank, and we are duty bound to apply every tool we can to clean up the mess that has soiled the face of our financial system."
Others, however, note that the Fed has not articulated a strategy to slim down its balance sheet and return to normal once the economy begins to grow again.
"It has a massive balance sheet that it has to bring back down," Prof. Meltzer said. "In my judgment, there is no mathematical model that will tell them how to do this. Acting too hastily has the risk of sending the economy back into recession. Acting too slowly lets inflation get going."
Returning to normal will be difficult considering the number of programs the Fed has started. Its rash of "liquidity facilities" began last December with cash auctions. As credit markets tightened in March, the Fed started a Term Securities Lending Facility to lend Treasuries to investment banks in exchange for mortgage-backed securities and agency debt.
After the collapse and Fed-orchestrated sale of Bear Stearns last March, the Fed opened its discount window to investment banks. This became less significant in September when Goldman Sachs and Morgan Stanley converted to traditional banks and Merrill Lynch sold itself to Bank of America Corp., but the facility continues to provide liquidity to smaller investment banks and the investment bank units of commercial banks.
Though it has won accolades for acting creatively in the financial crisis, many also argue that the Fed made a mistake in letting Lehman Brothers collapse in September. The failure was intended to send the market a message that the government was not in the bailout business. Instead, it sent shock waves through Wall Street, further drying up credit and destabilizing the market.
"What they did was massively increase the uncertainty when people were already uncertain," Prof. Meltzer said. "That was an enormous mistake."
He added that the Lehman failure only further muddied the market's understanding of which companies would be eligible for government rescue.
"In 95 years of history, the Fed has never announced a clear lender of last resort policy," Prof. Meltzer said. "Sometimes it bails them out. Sometimes it lets them fail."
Mr. Schneider said the Fed is unlikely to repeat this mistake.
"The Fed has wildly changed its definition of safety and soundness," he said. "It used to be OK for Drexel to fail. It wouldn't today."
Problems continued to mount for the Fed when one of the nation's largest money market funds "broke the buck" in the aftermath of the Lehman collapse. The Fed stepped in to lend to financial institutions against asset-backed commercial paper held by the funds.
By October, the Fed had made an $85 billion loan to AIG — an amount that was later shown to be too little — and took the unusual step of buying commercial paper from any issuer, not just a bank.
"The presumption was, banks have a certain special role in the market," Mr. Schneider said. "We've outsourced that to other institutions."
The Fed had to devise yet another rescue of the money market mutual funds in October by creating a facility that would take on their unsecured assets.
Just before Thanksgiving, the Fed worked with the Treasury and Federal Deposit Insurance Corp. to backstop Citi, agreeing to cover $306 billion in loans, and said it would buy debt from Fannie Mae, Freddie Mac, and the Federal Home Loan banks in an effort to reduce mortgage rates.
The liquidity support is unlikely to end there. Representatives of 11 commercial real estate trade groups are asking to be included in the Fed program that will be started in February to supply $200 billion in funding for asset-backed securities.
To many observers, the Fed has also become far more political during the financial turmoil. They point to the central bank's decision last week to complete rules for credit cards that were far tougher than would have been expected several years ago.
"That's really exhibit A," said KBW's Mr. Gardner. "They clearly have bent with the political winds."
The Fed also completed rules late last year designed to stop abusive lending and worked closely with the Treasury Department in pushing a bill this fall to create a $700 billion Troubled Asset Relief Program.
But Gil Schwartz, a former Fed lawyer who now works in private practice, said the Fed has always been political. It just finds itself in the middle of more hot-button issues now.
"Previously people have perceived the Fed as apolitical because the range of activities they were involved in were outside the scope of most people's radar and made it seem like they were far less political," he said. "How many people look at monetary policy issues and discount window issues? It's a very narrow range. Now, with the expansion of their activities into commercial paper and the insurance world, they become much more high-profile."