Bailouts and moral hazard
Bailout News, The Economy June 6th, 2008
This from CNBC:
Lacker: Fed May Have Made Financial Markets Worse
Federal Reserve intervention to calm financial market panic runs a moral hazard risk of encouraging more reckless behavior and may make matters worse in the future, a top Fed policy-maker said.
Richmond Federal Reserve Bank President Jeffrey Lacker, in a telephone interview, also said saving troubled U.S. investment bank Bear Stearns was an “excruciating dilemma” that warranted a major expansion of the Fed’s supervisory powers.
“The danger is that the effect of recent credit extension on the incentives of financial market participants might induce greater risk taking,” Lacker said in prepared remarks to a business group on Thursday.
This “in turn could give rise to more frequent crises, in which case it might be difficult to resist further expanding the scope of central bank lending.” Lacker spoke to a closed-door meeting of the European Economics and Financial Centre in London on Thursday.
A text of his speech was made available.
He said in the speech that market turmoil fell into two categories: non-fundamental episodes when rumors provoke runs on banks that are actually still sound, and strain caused when there is an actual decline in real fundamental asset quality.
“Instances of run-like behavior since last summer appear to be attributable to real fundamental causes, as do the broader financial market stresses,” Lacker said.
Central bank lending to calm market disruption due to deteriorating fundamentals is a natural reaction for policy-makers, but may sow the seeds for trouble down the way.
“The expectations such actions engender could very well make future crises more likely,” Lacker said.
The Fed and U.S. Treasury worked aggressively behind the scenes to ensure that Bear Stearns did not go under in March as lenders balked at extending it more credit.
The Fed promised up to $30 billion in emergency credit backstop to JPMorgan
