The recent actions of the US Fed to contain the damage in financial markets were extraordinary and unprecedented. Is the Fed pushing the envelope a bit too much? By Shivshankar Verma

In the good old days the role of central bankers, like everyone else's, was clearly defined. They were required to set monetary policy in accordance with their judgement of the prevailing economic conditions, based on interpretation of available data.

Their primary job was to protect the economy from the ill-effects of inflation, and then to achieve maximum employment. The second job demands active promotion of economic growth, which sometimes conflicted with the requirements for the first job which is inflation management.

This was the only dilemma faced by central bankers and if they had to make a choice, conservative central bankers always picked inflation management over economic growth.

Of course, lives of central bankers were more interesting during the many financial crises in the past. However they were expected to perform only one role in a crisis, that is, act as the lender of last resort. In other words, a central banker should always be ready to pump in money into the system during crises to ensure that banks have sufficient liquidity to meet their liabilities. This support from central banks helps prevent runs on banks during a financial crisis by providing a sense of security to depositors.

However, there was a catch. Central banks were expected to provide liquidity support only to depository institutions, or those firms, which accept deposits from the public. The simple logic behind this rule is that a public institution like a central bank should be bothered only about safeguarding the interests of the public, not private businesses.

Fed's Bear Bailout
Last week, the US Fed chose to ignore the long-standing central bank tenet of lending only to depository institutions. When investment bank Bear Stearns faced a severe liquidity crisis, the Fed was faced with a big dilemma. Allowing Bear to fail might severely erode confidence in the system, weaken the credit markets further, and cause troubles for traditional banks. That would harm Fed's efforts to provide some cushion to the fast falling US economy and even raise the spectre of total systemic collapse.

But, Bear Stearns was not a bank and there was no public money - as in retail depositors - involved. Even if the Fed decided to overlook this convention, it could not allow Bear to borrow from its discount window as that facility is open only to banks.

The Fed found a way out by using a traditional bank - JP Morgan in this case - as a conduit to provide liquidity to Bear. Then there was another problem. Usually, the Fed takes treasury securities as collateral for extending such liquidity support. Traditional banks do not have a problem with this collateral requirement as they are always loaded on treasuries. But, Bear did not hold sufficient treasuries to offer as collateral.

So, the Fed decided to relax the rules a bit. It announced that borrowers were now welcome to offer other paper including mortgage-backed securities as collateral. Bear had plenty of them, which were, in fact, the main reason behind its troubles.

Bear's troubles didn't end there. Before the end of last week, it was pretty clear that despite the liquidity support the firm was about to fail - unless someone strong and brave enough agrees to buy it. The Fed looked around and there was only one bank, which could bear Bear's liabilities. That was JP Morgan Chase, the least troubled of all US banks in the ongoing crisis.

But, JP Morgan knew it could strike a hard bargain as there was no competition. First, it offered a token - almost a throwaway - price for Bear Stearns. Then it dropped the bombshell - the Fed should back the mortgage-backed and other less-liquid securities, worth as much as $30 billion, that Bear was still holding. Without this, there would be no deal.

The Fed had no choice. It had to act fast, before the Asian markets opened on Monday morning. Bear is a large broker on Wall Street and many international clients had left the firm during the previous week. If Bear failed now, overseas clients of other brokers could also get jittery and start withdrawing the funds they kept with their brokers on fears of bankruptcy.

If that happened, brokers would be forced to sell their investment positions across global markets and there could be a sharp fall. This could heighten the risks of systemic failure.

The Fed caved in. It agreed to finance up to $30 billion in 'less liquid assets' - junk for all practical purposes - held by Bear. And JP Morgan took over.

Can the Fed afford to take these risks?
The rescue package for Bear Stearns has now been formalised by the Fed as a separate discount facility for primary dealers in government securities - which many Wall Street firms are. In other words, the Fed has now taken upon itself the role of a lender of last resort to primary dealers as well - instead of just commercial banks as earlier. And, it will accept a 'broad range of investment-grade collateral' as security at the discount window.

That is a huge risk. Until now, the Fed accepted only treasuries, which are risk free and, consequently, has never reported a real loss in its history. Now, it will accept securities which are riskier and which have the potential for losses. If more primary dealers use this facility, the Fed will end up with a sizeable holding of risky assets, which may decline in value.

How much funds the Fed will have to offer under the new facility? If the credit markets do not recover, it could run into hundreds of billions of dollars.

In a way, it is better if the Fed - which has the most holding power - holds these instruments. That will prevent primary dealers from dumping them into the open market, in the event of a crisis, and depressing their prices even further. But, by doing so, the Fed is exposing its own balance sheet to risks - something it has never done before. If it is forced to book losses in future, political and public reaction many not be very kind - even if it was the price paid for stabilising markets from which everyone benefits.

The rate cut that was absolutely necessary, but will do little
The Fed cut its key interest rate by 25 basis points over the last weekend, its first weekend decision in nearly three decades, and followed it by another 75 basis points cut two days later. While the inflation hawks were crying hoarse about the moral hazard after the earlier Fed rate cuts, this time around the reaction has been subdued. Everyone knows that this crisis is much worse than anyone had imagined and the Fed had to come up with drastic policy responses to have any chance of success.

The moral hazard allegations surrounding the Fed rate cuts are subdued also because stock markets have stopped responding positively to such moves. Every recovery after a Fed action in recent months has been short-lived and the markets always slipped further subsequently. Even the big rally after the latest rate cut was more in response to better than expected results from big Wall Street firms like Goldman and Lehman, which helped allay investor fears about other investment banks also going down like Bear.

The fact remains that lowering the Fed rate will not have any short-term impact on the US economy, which is now paying the price of 'incremental policy making' under former chairman Greenspan. Between 2003 and 2006, the Fed rate was hiked at a series of 'measured' but ineffective steps of 25 basis points each. This policy created the many bubbles that are now popping all around.

It will take time for the recent rate cuts to take effect and lift the US economy from dire straits. At the same time, asset prices may have to move down further before buyers are attracted back. All the Fed can do is to ensure that this process of the economy adjusting to the turn in business cycle is gradual, controlled and smooth.

We do live in extraordinary times with market complexities and interrelationships unfathomable even a decade back. It is inevitable that central banks like the US Fed will be forced to move out of their traditional comfort zones and take more proactive steps. While doing so, they have to be clear about their objectives and make sure that they don't create any unnecessary incentives to promote irresponsible behaviour by market participants. Else, we will end up with even bigger bubbles and when they eventually burst even the most powerful central bank will be clueless.