Federal Reserve & Interest Rates

United States Treasury Secretary Henry M. Paulson made a statement on Federal Reserve regulations on Wednesday, March 26, 2008 at the US Chamber of Congress. He expressed the need to slightly reform the lending practices of the Federal Reserve, urging more transparency and more informed lending decisions.

Secretary Paulson discussed the discount window operations of the Federal Reserve. The discount window offers a cash flow supply for commercial banks and allows the Federal Reserve to increase market liquidity. The Secretary suggested a few minor tweaks in the more recent lending to non-depository institutions that have access to the discount window on a temporary basis.

Secretary Paulson stated:

I believe a few constructive steps would enable the Federal Reserve to protect its balance sheet, and ultimately protect U.S. taxpayers….The Fed should describe eligible institutions, articulate the situations in which funds will be made available, and the magnitude and pricing structure for the funds. The TAF process is a good model for a structure that would provide relevant information to the marketplace.

…The Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions…We suggest that the Federal Reserve, the SEC, and the CFTC continue their work of building a robust cooperative framework… These regulators should consider whether a more formalized working agreement should be entered into to reflect these events.

With this added information flow, the Federal Reserve will be better positioned to consider market stability issues like liquidity provisioning and the interconnectedness of financial institutions. The Federal Reserve’s participation could also allow for broader consideration of market stability issues by the SEC and the CFTC. This collaborative process will necessarily have a strong focus on liquidity and funding issues.

The combination of these steps should provide the Federal Reserve with a structure and the information that it would need to make liquidity backstop loans during periods of market instability to non-banks.

It seems what Paulson is basically trying to say is that the Federal Reserve would be able to handle liquidity and funding issues better if they were not standing alone. More open communications with the Securities and Exchange Commission and the Commodity Futures Trading Commission would protect taxpayers and avoid moral hazard. Moral hazard in this situation is basically when banks have incentive to take higher risks because they know that the Federal Reserve will insure them or bail them out.