After sitting on the sidelines for the first nine months of the current mortgage crisis, the Federal Reserve took dramatic action in March. It opened the discount window to investment banks and orchestrated the bailout of Bear Stearns, assuming the risk of $29 billion of illiquid asset-backed securities.
The central bank justified its action by citing the overwhelming need to protect the payments system from collapse. Critics disparage the Federal Reserve's actions. They believe the Fed is encouraging future risky behavior by investment banks and their counterparties. The critics' preferred solution was to let Bear Stearns fail and let the imprudent suffer the consequences.
Economists call the critic's concern "moral hazard," the prospect that a party insulated from risk may behave differently in the future than how it would behave if fully exposed to its risk-taking's consequences. For example, an individual with insurance against automobile theft may be less vigilant about locking his or her car because the negative consequences of theft are (partially) borne by the insurance company.
These economists are right to be concerned about moral hazard — it has the potential to create financial inefficiencies when risks are displaced. However, the potential collapse of Bear Stearns presented a much greater threat than moral hazard; it called up the specter of systemic risk. This is the risk that a default by one market participant will affect other market participants in a cascade of damage due to the interlocking nature of the financial system. This risk cannot be diversified away, and all market participants, no matter how innocent, bear the costs of a systemic failure.
Make no mistake, the consensus is that Bear Stearns would have failed without Fed intervention. However, the central bank did not act to rescue the Bear Stearns franchise, employees, or shareholders. It acted to protect the interdependent system made up of banks and other financial institutions worldwide.
The concern among central bankers was that a Bear Stearns failure would have disrupted the global payments system and led to the collapse of the credit swaps and derivatives markets, catalyzing the collapse of heretofore sound financial institutions — perhaps even triggering a second Great Depression. Such an outcome is unacceptable regardless of the potential for moral hazard.
When a house is on fire, the responsible person puts it out before it spreads through the neighborhood, not worrying whether extinguishing the blaze might encourage smoking in bed.
The Bear Stearns rescue was not the first such Fed action. Its orchestration of the rescue of the hedge fund Long Term Capital Management, or LTCM, in 1998 was a graphic example, even under the light regulatory touch of Chairman Alan Greenspan, that the Federal Reserve would act outside the boundaries of its traditional institutional mission to prevent financial market failure.
The fact that the capital injected into LTCM came from large private-sector financial institutions dulled the recognition of the new reality that the need to protect the payment system extended beyond large banks. Nevertheless, the Federal Reserve should have viewed the LTCM near-collapse as a wakeup call highlighting the fundamental changes underway in the payment system and begun prudent planning for necessary regulatory changes.
Regardless of what the critics think, a new financial market reality prevails. The Federal Reserve has extended an implicit guarantee to the counterparties of investment banks that these institutions will not be allowed to collapse and default on their contractual obligations. This type of moral hazard is not new. In fact, large banks viewed as "too big to fail" have been operating with this implicit guarantee and the associated moral hazard for decades.
In addition, the moral hazard problem associated with large banks is made even greater by government-guaranteed deposit insurance. Any federally insured bank or other depository can borrow money (take deposits) with the full faith and credit of the federal government standing behind it regardless of its risk level or financial condition. Should a bank or other depository fail, for whatever reason, deposits up to $100,000 are repaid in full. In the case of investment banks, instead of a deposit guarantee, an implicit guarantee now extends to counterparties of credit swaps, derivatives, and other financial instruments.
The commercial banks' moral hazard is mitigated by subjecting them to government regulation and examinations intended to assure safe operating practices and sound financial condition. These regulations are not exceedingly onerous, as evidenced by the competitiveness of U.S. banks. The new financial market reality means investment banks and other institutions benefiting from the new implicit guarantee ought to be regulated similarly. In fact, it is the absence of such regulation in the current environment that makes moral hazard a problem.
The Federal Reserve acted responsibly and correctly to a systemic threat posed by Bear Stearns. However, because of Bear Stearns' rescue, investment banks' counterparties are likely to be less rigorous in evaluating risk.
The federal government should come to terms with the new reality that an expanded regulatory regime is needed to reduce moral hazard and assure the financial system's safety and soundness. Furthermore, just as banks have a self-funded deposit insurance system and regulatory regime, the investment bank regulatory regime should include self-funding for the regulator and a risk-sharing structure to help fund the implicit guarantees that follow from the Bear Stearns bailout.
