News Tip: Federal Reserve Should Shift Focus from Bailouts to Markets, Duke Professor Says
Steven L. Schwarcz, professor of law and business, says the Fed's move to save Bear Stearns will prove costly
Monday, March 17, 2008
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Steven L. Schwarcz can be reached for additional comment at (919) 613-7060 or schwarcz@law.duke.edu.
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 a Duke University law professor who is an expert in systemic risk.
The Fed’s continued focus on institutional assistance is “anachronistic and costly,” says Steven L. Schwarcz, Stanley A. Star Professor of Law and Business at Duke.
On Sunday, the Federal Reserve saved Bear Stearns from bankruptcy by shielding buyer JP 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,” says 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 won’t 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 says. “Indeed, the Fed could even have made a profit.”
Noting that capital markets, not banks, now represent the primary source of corporate financing, Schwarcz said it is time for the regulatory focus to also shift to protect markets.
Schwarcz has set out an approach to doing so — the result of a year-long study of systemic risk — in an article, “Systemic Risk,” forthcoming in the Georgetown Law Journal. In that paper, and in testimony to the House Committee on Financial Services in October 2007, Schwarcz recommended 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,” Schwarcz says.