Richmond Federal Reserve Bank president Jeffery Lacker is warning about consequences from the decision of the Fed to lend to securities dealers. Of concern is how investment banks are not subject to the same level of regulation and oversight as are commercial banks. Paraphrasing, Lacker points out that the effect of the recent credit extension on the incentives of financial market participants might induce greater risk-taking, and that this increased risk-taking could give rise to more frequent crises - the classic case of moral hazard.
Robert Eisenbeis from Cumberland Advisors points out that some of the Fed officials may be having "buyers remorse" with regard to going down the path of opening-up securities lending to investment bank. As a result, some are starting to discuss potential problems in public, possibly in an attempt to begin sending a message to the market that this is not something that the investment banks can always rely on. Many economist have pointed out that once the Fed bailed out Bear Stearns and opened up the discount window, they let the cat out of the bag and will have a difficult time getting it back in. As other investment banks run into trouble, they will no doubt be expecting similar treatment, including cheap borrowing and a market for illiquid assets.
Eisenbeis mentions possible ways to begin correcting the perception, including preventing investment banks from being prime dealers - in effect preventing them from being a conduit for implementing Federal Reserve policy. The Fed could also force the investment banks to change their charter, allowing the Fed more flexibility to take necessary actions to secure the assets available for borrowing. Nonetheless, any changes will be difficult. Since it is unlikely that the Fed will make any formal declarations, the market will no doubt have to wait until the next potential failure before it will know for sure what actions the Federal Reserve is willing to take. Hopefully this will not come sooner than later.
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