Valuable insights into the Federal Reserve often are ripe for the plucking, if you know where to look. Last month, Focus Forum readers were invited to view the world through the eyes of Chairman Ben S. Bernanke.
This month, Focus Forum highlights a speech by Fed Governor Randall S. Kroszner, made on Oct. 11 at the National Bankers Association's 80th annual convention in Durham, N.C. Kroszner's speech offers clear-speak insights into the actions and reasoning the Fed used to address problems in the credit markets starting in August.
The following is a paraphrase of Kroszner's speech, using as much as possible of his original words and phrasing.
Fed Governor's Take on What the Heck the Fed Does
As the nation's central bank, the Fed Reserve has the ability to conduct monetary policy for the U.S. economy. That enables it to provide liquidity—a capability that is particularly important when the financial system is under stress.
The Fed Uses Open Market Operations to Conduct Monetary Policy
The Fed conducts monetary policy primarily through open market operations with the purchase and sale of securities in the open market. This gives the Fed the ability to control short-term interest rates. The Federal Open Market Committee (FOMC) oversees the conduct of open market operations and formulates monetary policy by setting an operating target for the federal funds rate that is judged to be consistent with fostering the Fed's long-run objectives.
One Goal is Financial Stability
The Fed has a broad responsibility to foster financial stability. Keep in mind that financial stability does not imply that asset prices will be stable at all times or that investors will be protected from significant losses. Rather, financial stability is fundamentally about the efficient functioning of financial markets in channeling credit and financial resources to the most productive ends and allowing investors to effectively manage risks.
During periods of financial distress, the Fed can promote financial stability by providing liquidity through both open market operations and the discount window. It is important to note that the ability and willingness of the central bank to provide liquidity may be useful in reducing market uncertainty and bolstering investor confidence, even if the actual amount of liquidity provided turns out to be rather modest. For these reasons, the ability to provide liquidity is a critical tool of a central bank.
Fed Used a Variety of Tools in the Recent Credit Market Disruptions
In response to recent disruptions and strains in financial markets, the Fed used a range of policy tools—including adjustments in short-term interest rates and the provision of liquidity—during this time of market unrest to counter the potential ill effects on the economy. On Aug. 10, the Fed issued a statement announcing that it was providing liquidity to facilitate the orderly functioning of financial markets and would provide reserves as necessary to promote trading in the federal funds market at rates close to the target rate of 5 1/4 percent. The announcement also noted that the discount window was available as a source of funding.
On Aug. 17, the FOMC issued a statement noting that financial market conditions had deteriorated and that tighter credit conditions and increased uncertainty had the potential to dampen economic growth. The FOMC said that it judged the downside risks to growth to have increased appreciably and stated that it was prepared to act as needed to mitigate adverse effects on the economy arising from the disruptions in financial markets. At the same time, the Board of Governors announced that it had approved a 50-basis-point reduction in the primary credit rate at the discount window, to 5 3/4%, to promote the restoration of orderly conditions in financial markets.
Given the turbulence in the short-term funding market, the board also approved a change in the administration of the discount window that would allow the provision of term financing for as long as 30 days, renewable by the borrower. On Aug. 21, the Federal Reserve Bank of New York announced some temporary changes to the terms and conditions of the System Open Market Account securities lending program, including a reduction in the minimum fee, in an effort to facilitate lending of securities by the Fed to address heightened safe-haven demands for Treasury securities.
These actions appeared helpful in mitigating some of the strains in financial markets, but financial market functioning had not returned to normal by the time of the September FOMC meeting. At that time, the fed judged that a 50-basis-point lowering of the target federal funds rate was appropriate to offset the effects of tighter financial conditions on the economic outlook and reduce the risks that a further tightening in credit conditions could impact the housing market and lead to significant broader weakness in output and employment.
Fed Is Concerned about Nonbank Players
While the Fed's monetary policy role garners great media attention, its role in bank supervision and regulation is no less important. The Fed is well aware that the subprime mortgage market has presented supervisory concerns. The Fed takes two fundamental approaches to consumer protection: one focuses on the provision of information, and the other involves the development and enforcement of rules against abusive and unfair practices.
The regulatory scheme for the mortgage industry has become extremely complex as the breadth and depth of this market has grown over the past decade and the role of nonbank mortgage lenders, particularly in the subprime market, has increased. Independent mortgage companies—those that are not depository institutions, subsidiaries of depository institutions, or holding company affiliates—made about 46 percent of higher-priced first-lien mortgages in 2006. In addition, there has been an increased presence of mortgage brokers, often independent entities who take loan applications and shop them to depository institutions or other lenders.
What's Next on the Fed's Agenda for the Subprime Mess
The increased fragmentation of the mortgage process, from marketing of products to servicing of loans after origination, has created a number of challenges in monitoring practices of various nonbank market players. The Fed has launched a cooperative pilot project to conduct reviews of nondepository lenders with significant subprime mortgage operations. The reviews will evaluate the companies' underwriting standards and senior-management oversight of risk-management strategies for ensuring compliance with consumer protection laws and regulations.
The other agencies involved are the Office of Thrift Supervision, the Federal Trade Commission, and state agencies represented by the Conference of State Banking Supervisors (CSBS) and the American Association of Residential Mortgage Regulators.
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