Fed Official Says Rescues May Create More Risks

In a sign of widening skepticism within the Federal Reserve system of the central bank's rescue of Bear Stearns, the president of a regional Fed bank said yesterday that such actions may make financial crises more common.

The comments by Richmond Fed President Jeffrey M. Lacker reflect a concern among people within the central bank and close to it that the emergency actions taken over a single weekend in March may have fundamentally recast the role of the institution -- but without the lengthy, deliberative process that normally would precede such a move.

"The danger is that the effect of recent credit extension on the incentives of financial market participants might induce greater risk taking," Lacker told the European Economics and Financial Centre in London, "which in turn could give rise to more frequent crises, in which case it might be difficult to resist further expanding the scope of central bank lending."

Lacker did not specifically criticize the decision of Fed Chairman Ben S. Bernanke and New York Fed President Timothy Geithner to give financial backing for the emergency acquisition of Bear Stearns and to extend Fed lending to all investment banks. The actions taken March 16 were aimed at averting a global financial catastrophe, but Lacker expressed concern that that they created new risks.

"In times of financial crisis, the understandable central bank imperative is to alleviate the stress." Lacker said. "But the expectations such actions engender could very well make future crises more likely."

Others with close ties to the Federal Reserve system have expressed misgivings. The presidents of the Kansas City Fed and Minneapolis Fed have voiced concerns similar to those of Lacker, if not as directly. Former Fed chairman Paul Volcker said that the actions were on the edge of the central bank's legal authority.

Just yesterday, Philadelphia Fed President Charles Plosser said in a speech that the central bank should explicitly define in what situations it will intervene to protect an institution, because if officials simply use their discretion, it might encourage the taking on of too much risk.

Former St. Louis Fed president William Poole has attacked the actions explicitly as an undue interference in markets, and Vincent Reinhart, a senior staffer at the central bank until last summer, called it "the worst mistake in a generation."

In an interview yesterday, Reinhart said that the rumblings of discontent reflected a sense that the central bank's mission has changed without much forethought.

"You go back a few years, there was a settled consensus about the role of a central bank," said Reinhart, now a resident scholar at the American Enterprise Institute. "That has changed very rapidly, and the changes were driven by events. It's not clear anyone internalized the longer-term issues when they were solving that day's problems."

There have been other signs of disagreement within the Fed, reflecting both the complicated challenges the economy is facing and Bernanke's personal manner, which favors open debate. There has been at least one dissenter on every interest rate move at each meeting since the Fed's policymaking committee began cutting rates in September. Two members of the committee have dissented at the past two meetings.

Such open disagreement in crisis was unheard of when Alan Greenspan was Fed chairman.

Bernanke and his colleagues realized as they were taking the emergency actions in March that the moves could have momentous significance for the Federal Reserve. But they concluded the risks of not acting were greater than those of intervening -- failure to act could have caused financial markets to cease functioning, a massive loss of wealth and a deep global recession.

They also considered the possibility that ongoing financial events may have led to even more criticism and fundamental rethinking of the Fed's role than is occurring.

"We did what we did because we felt it was necessary to preserve the integrity and viability of the American financial system, which in turn is critical for the health of the economy," Bernanke told Congress shortly after that weekend.