The 1907 Panic and the ensuing response led by J. Pierpont Morgan made one thing clear: it was necessary to move beyond personality cults of individuals to tackle future financial crisis. Different plans to create an independent organization representing diverse financial institutions started to gain traction but the debate over the inherent subjugation of public interest in this arrangement raged on as well. Woodrow Wilson, as the winner of 1912 presidential elections, eventually started to shape the conversation towards a formal conclusion and proposed a combination of private and public representation in a central bank. The subsequent passage of the Federal Reserve Act created an institution that balanced centralized control enshrined in the government controlled Federal Reserve Board in Washington, D.C. by establishing twelve privately controlled regional banks catering to the specific needs of twelve geographical regions of the country.
Traditionally, the New York Fed has held a prestigious, and somewhat dominating, position among regional banks because of its hegemony over implementing the monetary policy of the Federal Reserve Bank and the fact that most of the financial powerhouses have concentrated operations in New York. Its organizational structure is composed of nine members (three bankers, three non-bankers chosen by the local banks and three members chosen by the Federal Reserve Board of Governors to represent the public); other regional reserve banks have the same structure. By design, this structure is dominated by bankers and can potentially influence Fed’s policy for the benefit of bankers at the detriment of other stakeholders including taxpayers.
This concern was particularly evident during the Great Recession. The President of the New York Fed, Timothy Geithner, furiously advocated governmental intervention in support of the troubled financial institutions. The very board members that chose Geithner as the overseer of their financial dealings were also representing the financial heavyweights in the industry. One member of the board, Jamie Dimon of JP Mogran Chase, later had an extensive role negotiating acquisition of Bears Stearns that was supported by Geithner’ New York Fed.
To some extent, it is understandable that there is a need of private sector expertise in the regulatory agency so that it can effectively regulate the industries. But the argument fell flat when AIG appeared on the radar as the potential candidate headed to the bankruptcy court. After the Lehman Brothers’ collapse and its shock reverberating throughout the international financial industry, it was evident that AIG needs to be saved at any cost because of its sheer size and the dependence of domestic and international customers on its insurance products. But how did AIG become such a behemoth with a mix of insurance and mortgage businesses? The prevalent answer is that it fell through the cracks (and landed on taxpayers’ shoulders for $183 billions). Why was there a gap in regulatory oversight or were regulators too close to the company’s management to scrutinize its transactions? Regardless of the underlying reasons, the AIG bailout definitely exposed the limits of the argument that industry expertise is a necessary and sufficient condition for effective regulation.
As the subprime mortgage crisis continued to escalate, the need of a precise and swift action to address new victims of the crisis increased as well. The Bush administration dispatched the Treasury Secretary, Henry Paulson, to harness the crisis along with Ben Bernanke and Timothy Geithner at the Fed. The Fed had an accelerated decision making process between Washington directors and twelve regional presidents away from the Congressional oversight. The lawmakers had already codified the Fed’s rules in law but now the Fed used liberal interpretation to extend these laws in new dimensions. The Fed exercised its power of electronic press markets under the “unusual and exigent circumstances” provision in the Constitution and intervened anywhere in financial markets that it deemed necessary. The collective malfunctioning of financial institutes with balance sheets malnourished due to accumulation of toxic assets forced the Fed to extend its mandate by pumping cash in the less-regulated shadow banking system whose potential collapse had dried up credit markets. Here are a few blatant examples of such transactions that passed the muster to comply with the letter of the existing laws but may have violated the spirit of the law: * The Fed extended a loan to JP Morgan Chase to acquire Bear Stearns but created a special purpose vehicle (SPV) entity that might have stretched its mandate to lend against a solid collateral. Ironically, many financial institutes were in their current state by exploiting and excessively using SPVs along with off-balance sheet accounting. * The Fed would employ a similar SPV entity to buy commercial paper from money market funds and other securities backed by untraditional assets for the Fed including auto loans, student loans and commercial mortgage-backed securities. The upcoming presidential elections of 2008 provided another reason for broader interpretation of the existing rules and regulations.
The two parties Democratic and Republican, were too busy scoring partisan points against each other and did not want to engage in another legislative battle that could provide more ammunition to the other party. When Henry Paulson approached Barney Frank about the pressing need for more power to deal with the potential failure of huge financial institutes, Frank told him to “take an expansive view of your powers, and I won’t criticize you for that” (Wessel 179). This particular example adds another twist to the principal-agency problem: who is responsible when a representative of principals is implicitly endorsing the agent’s action that is contrary to the principals’ intent? Alternatively, should the agent make the best decision possible in a climate constrained by the political partisanship with the necessity of a time-sensitive action?
The “best decision possible” is probably the best defense posed by different people involved in the sub-prime crisis management. Looking retrospectively, they could blame Alan Greenspan for keeping the interest rates low for too long and letting the bubble grow. They could harangue each other on their mutual inability to gauge the magnitude of the crisis earlier in its development and address it before it snowballed and threatened to destroy the whole economy. They could just punt the ball to the Congress and do nothing and let the Congressmen chart the new path for financial markets. But, looking prospectively, any other alternative would have left the financial markets in further turmoil increasing the cost of any intervention many folds and the Great Recession turning into the Great Depression No 2.
The strange irony of inaction followed by a full-throttle action renders the response to the Great Recession a failure and success at the same time in compliance with its duties. The Great Recession started with homebuyers’ lust for homes that they could not afford. Brokers and lenders tried to one-up their competition and cut corners, wherever possible, to issue the biggest mortgages possible in the shortest amount of time. Investment banks sliced and diced these mortgages in tradable securities; some of these securities were so complex that the issuing banks couldn’t quantify their own financial exposure attributable to these financial products. While the foreigners were pumping money into the US markets, the Alan Greenspan Fed kept interest rates at a record low for a record long time.
Further, the Fed failed to see the developing crisis under its myopic explanation that the new economic fundamentals were supporting the prolonged growth period. As the new financial products grew, the Fed neglected its duty of “supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers.” Even after BNP Paribas of France froze its three hedge funds that were trading US mortgage backed securities in August 2007, Geithner continued to believe that banks were well-capitalized. Unfortunately, the Fed officials did not recognize that the financial system was bursting at its seam until it had to facilitate Bear Stearns sale to JP Morgan Chase in March 2008. They also failed to anticipate the repercussions of allowing Lehman Brothers’ bankruptcy that froze credit markets around the globe.
Once the gravity of the situation became clear, the Fed starting firing on all cylinders in “maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.” Extending its “unusual and exigent” mandate, the
Fed tried to stabilize the markets be taking aggressive actions including the following: * Learning from the experience of Japan, it decreased its interest rate to zero in less than two years (the Bank of Japan took almost eights years). * It introduced Term Auction Facility (TAF) for any of 7000 banks in the country: buying risking MBS and selling out Treasury securities that added liquidity to the markets but couldn’t address institute specific issues * As investors flocked to dollar denominated US Treasuries, the Fed offered all the major central banks unlimited exchange of dollars for their currencies. * It introduced Term Securities Lending Facility (TSLF) to address the institute specific deficiency that will exchange toxic MBS for Treasury securities for up to 28 days.
The bold and experimental nature of these actions reflected the resolve of Ben Bernanke who had studied the Great Depression during his graduate studies. Whereas the inaction of the Fed contributed in extending the Great Depression, Bernanke did succeed in limiting the Great Recession into becoming another depression on his watch.
With the best of its intentions, Bernanke’s Fed failed in the domain of public perception and ranked lowest among all government agencies in one poll during 2009. The public saw Fed’s actions as a bailout plan for the Wall Street whereas the Main Street residents were being forced out of their houses. Bernanke understood the importance of explaining his actions directly to the American public through popular media outlets and how these actions translate into the kitchen table decisions of average Americans.
The aggregate impact of individual decisions can have an impact on national and international level as demonstrated by the subprime mortgage crisis. During my academic training at the Ford School, I am concurrently taking a course on Macroeconomics to understand the far-reaching consequences of the Fed’s actions for institutions and individuals. Furthermore, the course in International Finance Policy essentially extends macroeconomics to an international dimension and emphasizes the interaction of different financial system in the integrated financial markets of 21st century. Whereas Wessel provided a cursory journalistic detail about the impact of coordinated impact of interest rate reduction by major central banks during 2007, my other courses provide a detailed and in-depth analysis of limitation of the monetary policy in addressing a financial crisis. In addition, two other course, Politics of Public Policy and Public Management, have helped me understand the importance of good political policies in implementation of good economic policies.
I believe that the Fed currently collects plenty of data to construct different performance metrics but such metrics are of limited usefulness during a financial crisis. More importantly, from the perspective of making and implanting economic policy, the Fed should maintain its independence from political processes without any prescriptive advice from the lawmakers to deal with future crisis. At the same time, the Fed decision-making process should become more robust to identify and address systematic risks in financial markets.

Source Consulted:
Wessel, David. (2009). IN FED WE TRUST: BEN BERNANKE’S WAR ON THE GRET PANIC. New York: Random House.

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[ 1 ]. The shadow banking system includes less-regulated financial organization like hedge funds, money market funds and other non-bank financial institutions.
[ 2 ]. The SPV is generally a fully owned subsidiary of an organization that is used for derivate trading. This organizational structure can be abused to mask the true financial position of an entity.
[ 3 ]. Off-balance sheet accounting is used in the securitization of non-traditional loans including mortgage-backed securities.
[ 4 ]. The Federal Reserve System. “Mission”. Retrieved on 29 January 2012 from http://www.federalreserve.gov/aboutthefed/mission.htm.
[ 5 ]. The Federal Reserve System. “Mission”. Retrieved on 29 January 2012 from http://www.federalreserve.gov/aboutthefed/mission.htm.
[ 6 ]. GALLUP. “CDC Tops Agency Ratings; Federal Reserve Board Lowest”. Retrieved on 29 January 2012 from http://www.gallup.com/poll/121886/cdc-tops-agency-ratings-federal-reserve-board-lowest.aspx.