Response of Federal Reserve Bank To Financial Crisis Essay.

The financial crisis of 2007-2009 is stated as the worst since the great depression of
1930s. This crisis began in 2006 with the US mortgage market, and later spread to the entire US economy and around the world. In mid-2007, the crisis spread to interbank dollar funding market, causing a freezing of the dollar. Response of Federal Reserve Bank To Financial Crisis Essay. The worries of the distribution and the extent of the mortgage related losses become so extensive that the participants no longer had faith in the credit system, as well as the market, which provides US banks, and other dollar-based financial institutions with their liquidity becoming illiquid as a result.

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The financial system was imploding because, the commercial banks insurance companies, and the investment houses that were at the heart of the US financial systems could not borrow among
themselves. This was taking place when a lowering rate of confidentiality in the system was sending liquidity preferences down. This crisis moved the policies of the Federal Reserve, which were well established to multi-pronged triage that wedded traditional policy tools with new initiatives whose aim was to revive an ailing financial system.  Response of Federal Reserve Bank To Financial Crisis Essay.This paper aims at presenting an account of the policies that FED put in place, the framework used by the FED
to respond to the crisis, and the understanding of the crisis. 1
The evolution of the financial system and the role of non-banking institutions
A well-functioning financial system will advance with the economy, and this has been
true in the United States. For instance, depository (banks) institutions accounted for about
sixty percent of the assets held in the entire financial sector. However, by the year 2006, this
share fell to thirty percent 2 . The financial chains have extended beyond the banks to the market-based, non-bank financial institutions, which do not rely on deposits for their funding.
The financial systems have evolved such that the lending institutions may purchase shares in a money market mutual fund, which holds borrowing instruments such as commercial papers
issued by a bank, which engages in a repurchase agreement with a security firm.
The intermediation creates chains of inter-links, which make the whole system
vulnerable to shocks in any one market or at a single institution. Response of Federal Reserve Bank To Financial Crisis Essay. These inter-linkages
affectedly complicate supervision as well as information vital for monitoring the market and
its participants. They also complicate the ability of the Federal Reserve Bank (FED) and
other regulatory authorities to response quickly and effectively to financial crisis 3 .
As the financial system evolves in USA, the tools available for use by FED did not
replicate by evolving too. The tools that FED uses were essentially developed in the 1930s
during the great depression. Discount lending, and open market systems in addition to
affecting the bank reserves as well as the economy at large through bank lending channel, is
also affecting the overall levels of interest rates. 4 When the commercial banks are the largest
players in the system, these tools can be sufficient for quelling the crisis, but they are not
likely able to do so sufficiently in a financial system characterized by long intermediation
chains of market based intermediaries. Response of Federal Reserve Bank To Financial Crisis Essay.
When we look at the 2008 financial crisis, it was characterized by both a fall in the
market value of assets held by the financial institutions coupled with uncertainty over which
intermediaries are affected by the drop in asset value. Funding dries up because of lack of adequate information on the intermediaries’ exposure to the trouble assets as well as potential
troubled institutions with increased risk aversion 5 . The long intermediary chains compound
this effect, as firms are concerned with the balance sheet of their counterparts as well as those
of the firms in the intermediation chain. It is not enough to know, for example, the amount of
asset-backed securities or credit protection bought by an institution but the health of the
insurers of those assets as well as the soundness of sellers of insurance by way of credit
derivatives held by the institutions. Response of Federal Reserve Bank To Financial Crisis Essay. Gorton 6 says that concerns about the “fire sale” of assets
due to funding or liquidity problems or requirements to post additional collateral, and the
indecision of the exposures led to “funding runs. As a result, it becomes extremely difficult to
disentangle liquidity from solvency, particularly in circumstances bid ask spreads widen so
much that in many markets the price-discovery process breaks down. When confidence
collapses, the system slams to a halt and with it the economy 7 .
In crisis, the financial institutions require access to sufficient liquidity as well as
capital to put back confidence in the counterparts to successfully intermediate and thereby
keep the credit channel open up to support economic activities. This liquidity must be
accessed in a timely manner. The US experience during the crisis indicates that speed is vital
in preventing the unraveling of intermediation chains.
As this framework makes clear, the FED’s response to the financial crisis should be
understood within the context of the limitations of its tools, and again by the need to come up
with changes in the financial system. Response of Federal Reserve Bank To Financial Crisis Essay.

5 Micheal, Goodfriend. “Central Banking in the Credit Turmoil: An Assessment of Federal
Reserve Practice.” Journal of Monetary Economics 58, no. 1 (2011): 112-115.
6 Micheal 2011, 112-115.
7 Mark, Carlson. “The financial crisis and Federal Reserve policy.” The Economic History
Review 65, no. 3 (2012): 1199-1201.

The Responses the United States to the crisis and the use of traditional tools.
The response of US, of the Federal Reserve in particular, was decidedly
“interventionist.” The description of the policies of the Federal Reserve has three key tools:
discount lending, open market operations, and reserve requirements. As the financial crisis
spread in 2007, the FED responded in what we can call traditional manner with emphasis on
the target federal funds and primary credit rate 8 . going back to June 2006 up to August 2007,
the target funds rates was 5.25% and the primary credit rate was 6.25%; the 100 point wedge
between rates having been embraced at the time of the discount window overhaul in the early
2003 9 .
The US monetary authorities respond with a shift as well as large reduction in their
official interest rates, and by the end of 2008, the Federal Reserve’s overnight federal funds
target rate, was at just above 0.0%. this would be close to what the Federal Reserve chairman
Ben Bernanke has called its “zero lower bound” meaning, since the interest rate can be
positive, more interest rate reduction were impossible. 10 These efforts to stimulate the
economy through lower interest rates were accompanied by two different but related
developments that together implied an abandonment of the reserve bank traditional monetary
policy practices. The Federal Reserve also responded to the crisis by reorganizing itself as a
financial institution, which includes, changing the way through which it provided the credits,
to whom and on what terms it gives the credit. 11

8 Ben, Bernanke. “The Fed’s Exit Strategy.” Wall Street Journal, 21 July 2009, 10.
9 Ben 2009, 10.
10 Ben 2009, 14.
11 Thornton, D. “Is the FOMC’s Policy Inflating Asset Prices?” Economic Synopses, No. 18
(2011).

Realizing the US interest rates were already low ahead of the crisis and the
breakdown of the interbank market could not solved by a modest decline in interest rates, the
Reserve Bank become the lender to a variety of financial firms. This was not only the
commercial banks or within the country, but taking on the active management of the country
global liquidity and credit risks. 12 After holding the total size of its balance sheet constant for
more than one year, in September 2008, to counter the contractionary shock, which the events
of the month were sending by way of the world economy, FED used the ability to lend to
engineer the largest increases in the bank reserves in US history. This was an increase in
reserves more than it was necessary to push the federal funds percentage to zero, which the
banks absorbed as excess reserves 13 .
The response of the Federal Reserve was not super structural but material. The US
central bank changed the manner, in which it interacted economically with the US financial
systems, and by altering its material connection with the US interest-bearing capital. In this
way, it changed the financial system, giving the interest bearing capital a different as well as
new form of unity, embodied in its new operating procedures. During the entire crisis, FED
was the only institution of US to have a coherent response to the crisis. The response of the
treasury was weak and even incompetent by comparison, due to large part of the timing of the
crisis, coming towards the end of Bush administration and just ahead of President Obama’s
election in the end of 2008. In an effort to fill the gap, Federal Reserve assumed the
responsibility for all aspects of the US response to the crisis, subordinating the treasury. 14

12 Stephen, Cecchetti. Crisis and Responses: “The Federal Reserve in The Early Stages Of
The Financial Crisis.” Journal of Economic Perspectives 23, no. 1(2009): 51-75.
13 Cyree, Ken B, and Mark D. Griffiths. “Federal Reserve financial crisis lending programs
and bank stock returns.” Journal of Banking & Finance 37, no. 10 (2013): 3819-3829
14 Stephen 2009, 57-75. Response of Federal Reserve Bank To Financial Crisis Essay.

7

Quantitative Easing
This is a policy of purchasing a large quantity of longer-term assets as well as
maintaining a large portfolio of private and government debt. The Fed’s first LSAP occurred
when it announced that it would purchase up to 100 billion dollars in agency debt and up to
500 billion dollars in MBS to “support housing markets as well as foster improved conditions
in financial markets in general.” 15 The Fed’s chair pointed out that even though the policy
rates was effectively zero, Fed would purchase long term treasury or agency securities on the
open market.
Quantitative Easing occurred on March 2009, when the Federal Open Market
Committee (FOMC) announced that “to give more support to mortgage lending as well as
housing markets,” it decided to expand its asset purchase program by buying an additional
1.25 trillion dollars. A second program of Quantitative Easing was announcing on November
3, 2010, when FOMC decided to buy additional 600 billion dollars of long-term treasury
securities at the pace of about 75 billion dollars. 16
The actions by the Federal Reserve to expand lending broaden the acceptable
collateral against which it would lend, as well as lengthen the maturity of its lending and it
acknowledged the narrowness of the traditional tools set to deal with modern financial
crisis 17 . Judging the effectiveness of the facilities as well as emergency actions of the FED is
complicated task by the absence of the counterfactual had the policies not been followed.
While the effectiveness of personal initiatives will be a continuous debate, the key issue is to

15 Krishnamurthy, A., and A. Vissing-Jorgensen. “The Effects of Quantitative Easing on
Interest Rates: Channels and Implications for Policy.” Brookings Papers on Economic

consider what comes next for the initiatives as well as how supervisory and regulatory policy
can be shaped to improve the system.

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New tools Used by the Fed
Prior to the crisis and before the crisis got out of hand, the open market operations
among other traditional tools were the Fed’s principle policy tools. Only the banks
maintained reserve with the Federal Reserve, and only the United States banks could get
financing from the Fed’s primary discount window. After 2007, the Federal Reserve started
to behave differently. It started advancing its own credit against collateral, and not only to US
commercial banks, against the government’s bonds or for interest rate purposes. In September
2008, it flooded the US financial system with its zero interest rate, but essentially riskless
liquidity. Response of Federal Reserve Bank To Financial Crisis Essay.
In December 2007, the Federal reserve come up with two lending facilities; a system
of foreign exchange swap lines with central banks of oversee countries, under which it gave
them access to the dollar, which they then lent to their troubled banks, and a Term Auction
Facility (TAF), under which it lent the commercial banks federal funds for one month. 19
These facilities in a quick way became the principle means through which the Federal
Reserve Bank created new credit. Meanwhile, behind the scene, Fed adjusted its portfolio of
the treasury securities to accommodate its new reliance on lending. As it raised the amount of
credit using TAF and the swap lines, it reduced its holding of US treasuries by a similar
amount. This helped in keeping Fed’s portfolio of loans as well as securities and the size of
its liabilities to bank institutions in the form of bank reserves roughly constant. In response to
the instability, which overtook the US financial markets in March 2008, it established a program under which it began lending primary dealers US treasury securities against a
variety of collateral, seized 30 billion dollars in non-performing mortgage-related credit
securities from Bear-Stearns on the 14 th and gave primary dealers and thus investment banks
access to its discount window. Response of Federal Reserve Bank To Financial Crisis Essay.
The initial response of the Federal Reserve to the crisis was very radical one. Between
December 2007 and March 2008, the Federal Reserve transformed itself from being a
participant in the Treasury market into a direct lender, replacing treasuries with less liquid as
well as credit worthy loans on the asset side of the balance sheet. The bank absorbed a
massive quantity of distressed assets, increasing its risks incalculably. However, Fed did not
supply any new money, engaging in a swap of its good and liquid credit for the private
sector’s frozen and bad credit 20 . Fed took measures to bring the money market back to life,
assuming the US financial system as a whole had enough of liquidity in the right places, and
as it was increasing its lending. The bank also accepted less credit worthy securities as
collateral, all the while reducing its holding of “safe” US treasury to keep the money supply
constant. 21
The Federal Reserve’s Response in perspective
Criticism to the Fed’s behavior since the beginning of the crisis focuses on its failure
to prevent the crisis from worsening. In the least, it is argued that the Federal Reserve should
have engaged in quantitative easing earlier. However, central banks are known to be highly
conservative institutions, and when they exercise their lender of last resort responsibilities,
they are not always very generous. 22 Federal Reserve intervention into the US economy in response to the crisis was decisive and massive. It gave shelter to its interest bearing capital
through giving it with ample quantities of order-creating liquidity, therefore, avoiding an acute political crisis in which the hegemony of US capitalism would be thrown into doubt. Response of Federal Reserve Bank To Financial Crisis Essay.
In the midst of the great depression of the 1930s, Keynes famously asked why anyone
in the outside a lunatic asylum, which use money store of wealth, for it, is a characteristic of
money as store of wealth, which is barren, whereas essentially every other form of wealth
yields some form of profit and interest 23 . He answered this by saying that central banks have
similar feelings about money as the banks, financiers, and industrialists who participate in the
interest bearing capital. This common feeling, he said, causes them to respond to crisis in highly different ways. Response of Federal Reserve Bank To Financial Crisis Essay.
For the first full year of the crisis, the Fed did not lend as it had “commonly” lent
prior to the crisis, but it did not follow the “worst of the policy” which is to “lend a great deal,
and yet not provide the public confidence that you will lend effectively and sufficiently.” In
the beginning of 2008, it lent all the while reassuring the public that it would go on lending.
The Federal Reserve, from the point of capital, exercised its duties in a responsible and
sensible manner. At the end of 2008, Federal Reserve had diffused the impression that money
was dear as long as financial capital was in trouble, and the dollar maintained its dominance
internationally. 24
Conclusion and reasons learnt
22 Fettig, David. “The History of a Powerful Paragraph.” The Region, Federal Reserve Bank
of Minneapolis 1, no. 1 (September 2010).
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3485 (accessed
March 30, 2014).
23 Adrian, Tobias, and Hyun Song Shin. “Money, Liquidity, and Monetary Policy.”
American Economic Review 99, 2 (2009): 600-605.

24 Adrian and Hyung 2009, 600-609

Fed massively increased the monetary base in the early months of 2008 when it
should have but did following financial crisis. There have been policies been put in place to
ensure that financial firms have what is required through appropriate capital requirements
against the risk taking activities is vital for mitigating moral hazards problems as well as
maintaining confidence in the system. Essential capital requirement are a piece of the puzzle. Response of Federal Reserve Bank To Financial Crisis Essay.
High capital needs on banks or other financial firms can lead to strong incentives for getting
around them, by way of balance sheet activities or activities, which are taken by entities not
facing the requirements 25 .
Giving supervisors the ability and information to monitor risks through the system,
not just in traditional banks, is important part of improvement going forward. International
cooperation will be a necessary part of this. Proposals range from giving powers to the
Federal Reserve, to setting up a system risk council of existing regulators including the
Federal Reserve, to taking away powers from existing regulators as well as giving them a
stand-alone Financial Supervisory agency 26 .
Some have said that a return to the separation of investment and commercial banking
embodied in the Glass-Steagall Act, and this would insulate the financial institutions from
market shocks as well as promote stability.
The long run economic consequences of such a policy are hard to predict. However,
these policies can have consequences for the monetary policy; namely, loss of influence and
credibility as the rising extreme policy actions generate smaller as well as perhaps worse
outcomes. 27
25 Allen, F, and Gale, D. Understanding Financial Crises, Clarendon Lectures in Finance.
(Oxford: Oxford University Press, 2007) 139.
26 Brewster 2011, 92.
27 Allen and Gale 2007, 89. Response of Federal Reserve Bank To Financial Crisis Essay.

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References

Allen, F and Gale, D. 2007. Understanding Financial Crises, Clarendon Lectures in Finance.
Oxford: Oxford University Press.
Goodfriend, M. 2011. Central Banking in the Credit Turmoil: An Assessment of Federal
Reserve Practice. Journal of Monetary Economics 58, no. 1, 112-115.
Krishnamurthy, A., and A. Vissing-Jorgensen. 2011. The Effects of Quantitative Easing on
Interest Rates: Channels and Implications for Policy, Brookings Papers on Economic Activity
1, no.1: 215-65. Response of Federal Reserve Bank To Financial Crisis Essay.
Adrian, Tobias, and Hyun Song Shin. 2009. Money, Liquidity, and Monetary Policy.
American Economic Review 99, 2: 600-605.
Thornton, D.2011. Is the FOMC’s Policy Inflating Asset Prices? Economic Synopses, No. 18.
Bernanke, Ben. 2009. The Fed’s Exit Strategy. Wall Street Journal, 21 July, 10.
Fettig, David. 2008. The History of a Powerful Paragraph. The Region, Federal Reserve Bank
of Minneapolis 1, no. 1 (September).
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3485 (accessed
March 30, 2014).
Swagel, Phillip. 2009. The Financial Crisis: An Inside View” Brookings Papers on Economic
Activity. Spring 30 June, 3.
Carlson, Mark. 2012. The financial crisis and Federal Reserve policy. The Economic History
Review 65, no. 3: 1199-1201.

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Cecchetti, Stephen G.2009. Crisis and Responses: The Federal Reserve in The Early Stages
Of The Financial Crisis. Journal of Economic Perspectives 23, no. 1: 51-75.

Wall Street Journal. 2012. The Music Men, Wall Street Journal, 1 August. Response of Federal Reserve Bank To Financial Crisis Essay.

Cyree, Ken B, and Mark D. Griffiths. 2013. Federal Reserve financial crisis lending programs
and bank stock returns. Journal of Banking & Finance 37, no. 10: 3819-3829.

Financial crisis review of Federal Reserve System financial assistance to American
International Group, Inc.: report to congressional requesters. Washington, D.C.: U.S. Govt.
Accountability Office, 2011. Response of Federal Reserve Bank To Financial Crisis Essay.