Fighting a Financial Crisis

The Federal Reserve made the bold move this weekend to extend the discount window to investment banks. The Fed's lender-of-last-resort function is normally reserved for commercial banks and bank holding companies.

In an attempt to calm the financial markets after the essential collapse of Bear Stearns, the Fed has extended this safety net to investment banks as well. At the same time, the Fed lowered the discount rate to 3.25% only 25 basis points above the current federal funds target although the target is expected to be lowered at the meeting on Tuesday. It is not clear how long the Fed expects to maintain this reduction in the premium on discount loans.

Investment banks are large players in the smooth functioning of financial markets. Until this new lending facility from the Fed, these investment houses did not have a government safety net. I believe the Fed is hoping that the availability of support from the Fed will decrease the uncertainty plaguing these investment banks to the extent that the loans will not even be needed. After all, the last time the Fed took steps to extend the discount window was when the markets tumbled after September 11, 2001. The availability of support from the Fed was enough to calm the market and very few loans were actually extended.

The fundamental question: Will all this frantic activity by the Fed instill confidence or increase uncertainty?

Let me know what you think.