Fed Warns Market Conditions Are 'Far From Normal'

Source : The Business Times, May 14, 2008

But liquidity moves have helped relieve strain: Bernanke

(SEA ISLAND, Georgia) US Federal Reserve chairman Ben Bernanke said yesterday that emergency Fed liquidity measures have helped relieve strain in financial markets, but the recovery process remains incomplete.

'To date, our liquidity measures appear to have contributed to some improvement in financing markets,' he told the Federal Reserve Bank of Atlanta's annual markets conference. 'These are welcome signs, of course, but at this stage conditions in financial markets are still far from normal. A number of securitisation markets remain moribund,' he said via video link from Washington.

He said that the central bank will increase its auctions of cash to banks as needed. 'We stand ready to increase the size of the auctions if further warranted by financial developments.'

The Fed chief's comments contrast with those by Treasury Secretary Henry Paulson and Wall Street leaders including Vikram Pandit, chief executive officer of Citigroup Inc, who say the worst of the credit crisis is over.

Mr Bernanke noted a 'substantial' improvement in the market for Treasury repurchase agreements and narrower spreads on agency mortgage-backed securities and corporate debt. But risk spreads remained generally high, while strong demand from financial institutions for liquidity from the Fed showed that funding problems persist.

The flight from risk since last August has made financial institutions reluctant to lend to each other, driving up banks' borrowing costs.

'Ultimately, market participants themselves must address the fundamental sources of financial strains - through deleveraging, raising new capital, and improving risk management - and this process is likely to take some time,' Mr Bernanke said. He added that the size of auctions of liquid funds for banks under the Term Auction Facility created last December, which already have been increased to US$75 billion from US$20 billion, could be upped again if demanded by market conditions.

The Fed has slashed interest rates by 3.25 percentage points since mid-September and pumped billions into financial markets to stop them seizing up amid a global credit crunch sparked by the US sub- prime mortgage crisis.

Controversially, the Fed's steps also included a massive cash line that enabled JPMorgan to rescue faltering investment bank Bear Stearns. Defending the Fed's actions, Mr Bernanke said a Bear Stearns bankruptcy could have touched off a much broader liquidity crisis.

He acknowledged intervention risked a moral hazard that investors would renew risky behaviour in the expectation of being protected by the central bank. But he said regulation ahead of a crisis was the best way to address that risk.

'The problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis,' he said.

'In particular, future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing,' he said, noting that bank supervisors aimed to ensure that institutions had adequate risk-management measures in place.

Mr Bernanke said the creation of the Term Auction Facility seemed to have overcome 'to a significant degree' the stigma of borrowing directly from the Fed at its traditional discount window. Banks are often hesitant to borrow at the window worrying that their borrowing will become known by market participants, who might view them as being in distress.

He also said measures to provide liquidity to large Wall Street dealers had been helpful, saying that they appeared to have bolstered confidence among dealers' counterparties. -- Reuters, Bloomberg