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Fed moves to minimise systemic risk
By Krishna Guha in Washington
Published: March 14 2008 14:18 | Last updated: March 14 2008 18:36
Friday’s action by the Federal Reserve marks the first time since the 1960s that the US central bank has authorised the provision of emergency finance to any financial institution other than a regulated deposit-taking bank.

As such it marks a dramatic expansion of the Fed’s role as lender of last resort for the financial system, while highlighting the shortcomings of its efforts to ensure adequate liquidity across the financial sector.

Analysts speculated that the Fed could be forced to provide emergency finance to other investment banks and possibly even some hedge funds in the weeks ahead. In a statement, the Fed said its move was intended to “promote the orderly functioning of the financial system”. Fed officials said it was acting because of the “systemic issues” involved.

One official said Bear Stearns was too “interconnected” to be allowed to fail at a time when financial markets are extremely fragile. The fifth largest investment bank, Bear Stearns is a big factor in the credit default swaps market, a prime broker to many hedge funds, a primary dealer in the bond market and a counterparty to many leading Wall Street firms.

The Fed official said that, in normal times, the bank would have been much less likely to intervene and it was not making a policy decision to make emergency funds available to all investment banks. Other requests for rescue financing would be treated on a case-by-case basis, he said.

In practice, the Bear Stearns precedent makes it more likely such finance would be forthcoming in the current market conditions, analysts said. However, the Fed will be deeply reluctant to make emergency funds available to even a systemically important hedge fund.

A second Fed official said that providing emergency funds to an unregulated financial institution would create serious moral hazard. Moreover, even large hedge funds are not as complex as Bear Stearns in terms of their connections with the rest of the financial system.

The Fed said it was acting under section 13.3 of the Federal Reserve Act, which gives it authority to lend to any individual, partnership or corporation “in unusual and exigent circumstances”. (SO ALL BORROWERS CONTACT FED FOR A DIRECT LOAN!!!)

That authority was last invoked in the 1960s and Fed officials said loans were last actually disbursed in the 1930s.

As an investment bank, Bear Stearns did not have access to the Fed’s emergency lending facility, the discount window. So the Fed arranged back-to-back transactions with JPMorgan to give Bear indirect access to the window.

The central bank took on the credit risk. The New York Fed will exercise discretion over how deeply it will discount the collateral.

The fact that the Fed had to resort to this mechanism highlights the shortcomings of the new liquidity support operations rolled out in recent days to give Wall Street firms such as Bear Stearns access to cash.

As a primary dealer in the bond market, Bear is eligible to take part in the new $200bn securities lending facility that will allow dealers to swap hard-to-finance mortgage securities for Treasuries with the Fed.

But the SLF, like the Fed’s new one month term repo operation, operates through twice-monthly auctions. The first auction does not take place until March 27. Bear evidently could not wait.

Even once the SLF is in operation, it will not work as a channel for emergency financing. What it might do is reduce the likelihood that other investment banks run into liquidity crises in the first place.
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