Are feds bailing out wrong people?

USA Today (Society for the Advancement of Education), May, 2008

In order to stave off a systemic collapse of U.S. financial markets, the Federal Reserve should shift its focus from protecting banks to protecting markets directly, according to Steven L. Schwarcz, professor of law and business at Duke University, Durham, N.C. In a much-publicized case, the Federal Reserve saved Bear Stearns from bankruptcy by shielding buyer J.P. Morgan Chase & Co. from obligations arising out of the cut-rate purchase.

"Even if it works in this case, it addresses only a symptom of the underlying disease, which is the lack of confidence in the credit markets generally," indicates Schwarcz, who points to market failure as the trigger for the current crisis. "The Fed now has to address symptoms as they come up, which will be costly both in direct costs and in 'moral hazard,' as well as other ways."

Moral hazard arises when big institutions like Bear Stearns take unnecessary risks, knowing that the Fed will not let them fail. "Moral hazard could have been virtually eliminated if the Fed had stepped in at the very outset of the subprime crisis and tried to shore up the markets by purchasing securities at a discount," Schwarcz insists. "Indeed, the Fed could even have made a profit."

Noting that capital markets, not banks, currently represent the primary source of corporate financing, Schwarcz maintains it is time for the regulatory focus to shift. He even set out an approach to doing so--the result of a year-long study of systemic risk--in testimony to the House Committee on Financial Services. Schwarcz recommends creating a governmental "liquidity provider of last resort. Doing so might require some amendment to the Federal Reserve Act, but Congress could do so very quickly if the Fed requested it," he surmises.