Bernanke Says More Needed to Stabilize Financial System

By: • Tue, Jan 13 2009, 9:51 AM

More measures are needed to combat the credit crunch and provide additional liquidity to the financial system, according to Fed Chairman Ben Bernanke in a speech Tuesday to the London School of Economics.

Bernanke argued that, "more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets," in addition to the possibility of a government purchase program of illiquid assets, the expansion of the Fed's asset-backed securities facility, and the possibility of the Fed purchasing U.S. government debt.

His comments come just one day after U.S. President George W. Bush asked Congress to release the next $350 billion tranche of the TARP, and at a time where congressional leaders are engaging in legislation to put limitations on how the money will be spent, including requirements that some of the money go to limiting foreclosures and bail out other non-financial institutions.

While Bernanke applauded the incoming administration's intentions to deploy an ambitious fiscal stimulus package, he argued that "fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system."

The Fed Chairman also recommended that additional efforts be made to reform the financial infrastructure of the United States, including the regulatory system, "for example, by encouraging the migration of trading in credit default swaps and other derivatives to central counterparties and exchanges."

In particular, he singled out financial institutions considered "too big to fail" as one of the greatest threats to financial stability in that they were not only the biggest risk takers during the financial debacle, but also prevented a "level playing field among financial institutions."

Addressing concerns over the Fed's "exit strategy" for when the central bank's purchasing program become unnecessary, Bernanke said that as credit conditions return to normal, many of the facilities established under "usual and exigent" circumstances (dictated in the section 13(3) of the Fed's charter) will have to be eliminated by law.

Furthermore, a "significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds - including loans to financial institutions, currency swaps, and purchases of commercial paper - are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down," he said.

Bernanke's comments are the first since Dec. 4, when he mentioned that the Fed was considering purchasing securities to help bring down interest rates in the United States. Since then, the Fed has cuts rates to zero and embarked on a massive quantitative easing policy, buying a wide range of mortgage-backed securities and agency debt.

In a question and answer session following his speech, Bernanke said that no one is trying to impose morality on the financial system, but rather make it work. Bernanke said that he would not describe the current crisis as "a crisis of capitalism", adding that is a difficult to find right combination between regulations and free markets.

When asked about the economic situation in the UK, Bernanke said that there are some commonalities between what the U.S. and UK is going through. He also added that both countries' central banks worked together to co-ordinate rate cuts in the past. Bernanke added that he doesn't need to give advice to the UK.

When asked about the problems of government-sponsored enterprises Fannie Mae and Freddie Mac, Bernanke said "I think that the problem was that they didn't have enough capital... the thin sliver of capital was insufficient." He added that inadequate market discipline also contributed to the problem. Bernanke said "what to do next" with Fannie and Freddie will be a big a challenge for the next U.S. administration.

When asked about job losses, Bernanke noted that the U.S. lost 2% of all employment in 2008. He added that he expects to see further weakness in the first quarter with some stabilization setting in the latter part of 2009. Bernanke also added that in the last two recessions, it took time for the jobs market to recover.