Is the Fed Creating a Moral Hazard?

Federal Reserve Vice Chairman Kohn has floated the idea of giving Wall Street securities firms permanent access to Federal Reserve loans conditional on imposing greater regulatory oversight. While temporary Fed lending to these firms has helped stabilized markets during the subprime meltdown, longer term moral hazard has been established by creating expectations that both the Wall Street banks and primary securities deals may rely in the future on big Fed bailouts.

Federal supervision of the large New York banks failed to curtail abuses of structured investment vehicles, credit default swaps, and other highly engineered products that caused the crisis. No one should expect that extending the same regulatory oversight to the primary dealers in U.S. government securities would have any greater effect on their conduct than it has had on U.S. banks.

"Extending the discount window or other Federal Reserve facilities to the securities companies without addressing these serious gaps in regulatory oversight would only increase the probability of arrogant abuse." -Peter Morici

So far the Federal Reserve has not extracted improvements in the quality of business practices at New York banks in exchange for the huge special lending facilities it has provided. Wall Street executives continue to prowl for lucrative opportunities in outside business lending and mortgage markets rather than create more transparent collateralized debt obligations that would restore liquidity to adequate levels for business lending and home building.

Further, we saw proof this week in deepening habits of deceit. Citigroup, J.P. Morgan Chase and others have been understating by wide margins their borrowing costs for Libor calculations. This deliberate pattern disguises the falling confidence knowledgeable credit market players have about the strength, solvency and integrity of these institutions.

The large banks and securities dealers have demonstrated by their actions and the costs their flawed business practices have imposed on shareholders, creditors and creditor customers that current public regulation is inadequate, and that they are incapable of self regulation. The government regulation has failed, private regulation has failed, and the market is too confused by false and misleading information supplied by the banks to fill the void.

Extending the discount window or other Federal Reserve facilities to the securities companies without addressing these serious gaps in regulatory oversight would only increase the probability of arrogant abuse, further proliferation of shoddy lending and securitization practices, and future credit market crises.

Before the Fed throws away any more of the taxpayer money under girthing Citigroup and others, it should begin to take more seriously its regulator role and condition its largess on real reforms in business practices.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.