Capital Markets

Bernanke: “Markets Are Still Far from Normal”

The Fed chairman defends recent moves to stabilize the markets and says any expectations of future government bailouts will be defused through stri...
Tim ReasonMay 13, 2008

Financial markets are recovering from the worst of the subprime crisis, but remain “far from normal,” said Federal Reserve Chairman Ben Bernanke in a speech Tuesday.

Speaking via satellite to the Federal Reserve Bank of Atlanta Financial Markets Conference in Sea Island, Georgia, Bernanke focused primarily on justifying the Federal Reserve’s decision to open its discount lending window to Bear Stearns and to primary dealers in mid-March. Bernanke cited the work of 19th-century economist Walter Bagehot, who said the role of a central bank during a liquidity crisis is to lend freely.

Bernanke said the Fed’s actions had helped stave off an immediate crisis, noting that liquidity in several markets had improved and spreads on a number of financial instruments, including corporate debt, have declined from recent highs.

However, Bernanke warned, “conditions in financial markets are still far from normal. A number of securitization markets remain moribund, risk spreads — although off their recent peaks — generally remain quite elevated, and pressures in short-term funding markets persist.” He added that spreads of term dollar Libor over comparable-maturity overnight index swap rates remain abnormally high, and that strong participation at recent Fed credit auctions indicate that credit remains hard to come by for many institutions.

Although Bernanke cited Bagehot’s theories as justifying the Fed’s actions, Bagehot also warned that central bank lending in a time of crisis should carry a high-interest rate to avoid creating a moral hazard. Explaining why the Fed had deviated from Bagehot’s prescription in that regard, Bernanke noted that Bagehot, writing in 1873, was writing about the Bank of England, which at the time was a quasi-public institution working within a gold standard with limited holdings.

Today, he explained, “potential limitations on the central bank’s lending capacity are not nearly so pressing an issue as in Bagehot’s time.” Thus, Bernanke hinted strongly that any moral hazard would be more effectively short-circuited through regulation and that future regulations will require banks to carry more protection against a sudden loss of secured financing. “The problem of moral hazard,” he said, “can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis.”

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