Denting confidence again

The rapid developments last week that saw Bear Stearns being acquired by JP Morgan Chase, with the substantial backing of the US Federal Reserve at a rock-bottom price of $2 per share, has opened up a new level of uncertainty about the scope and impact of the financial crisis in the US. Notwithstanding the repeatedly expressed concerns about "moral hazard" emanating from the bail-out of teetering financial institutions, both the Bank of England (with Northern Rock Bank) and the US Federal Reserve (with Bear Stearns) have obviously decided that discretion is the better part of valour and bankrupt institutions pose a more immediate threat than future moral hazard. Of course, the Fed's support mainly provides a temporary flow of liquidity to meet immediate obligations while new sources of funds are found. While the immediate objective of preventing the institution from going under has been achieved, markets around the world are now even more worried about the vulnerability of other institutions. As the guessing game about who might be next intensifies, the ability and willingness of central banks to continue to rescue floundering institutions must also be questioned. The dilemma posed by the choice between a calibrated approach to monetary policy and the almost knee-jerk responsiveness to financial distress, as demonstrated in the Northern Rock and Bear Stearns episodes, is striking.

An unending infusion of liquidity into the system, which is what would result from large-scale bail-outs, enhances the inflation risk, which the Fed and other central banks are quite acutely conscious of. Oil prices are at around $110 per barrel and other commodities, including major food items, are also in an inflationary spiral. While the Fed has cut its benchmark federal funds rate by 125 basis points this year, with expectations of another 50 basis point cut, the prevalent inflationary situation makes cuts beyond that point less and less likely. The question is whether a federal funds rate of 2.5 per cent will be enough to stimulate the financial system into getting lending going again. Remember that the rate had declined to 1 per cent during the previous cycle when, of course, inflation was nowhere amongst the perceived threats. If not, the risks of financial institutions of various kinds continuing to fail remain, and the Fed and other central banks will have to either let them fail or surreptitiously stoke the inflationary flames by the kind of crisis management seen in the Bear Stearns rescue.

A major problem in this situation is that nobody knows the extent of vulnerability of the major financial players. While commercial banks are regulated closely and their risks are visible, other financial institutions have a great deal of flexibility in managing their portfolios. This is as it should be, from a business viewpoint, but it makes a crisis more difficult to manage. Just as the previous crisis provoked the Global Settlement, which mandated a separation between equity research and business activity by the investment banks, this one could result in stronger disclosure and risk management norms for the sector. Macro-economic management is a difficult enough job in the best of times. It is being made even more complicated by the relatively opaque regime in which many of the key players in the current crisis operate. To the extent that more transparency brings about greater alignment between macro-economic and financial sector stability, it must be pursued.