This decision tree summarizes how the Fed responds to potential financial crises. After getting a reading on the economy’s vital signs, the Fed determines whether the threat at hand might compromise the central bank’s three primary goals.
If the Fed sees little risk, no action is taken, avoiding moral hazard and leaving the markets to sort out the difficulties. The Fed reacts this way to nearly all potential troubles in the financial sector.
A pervasive threat to the overall economy or the financial system can justify direct action. The Fed rarely makes these interventions; when it does, it strives to manage the resulting moral hazard in the least costly way.
The first choice entails the Fed’s acting as an outside coordinator to bring together private institutions to defuse the threat. It’s a strategy that minimizes public-sector risk, and the central bank used it with the Long-Term Capital Management hedge fund in 1998.
When this option isn’t feasible, the Federal Reserve Act provides the authority to deal directly with pressing threats. The preferred strategy involves forging partnerships with private institutions, a course the Fed took in March 2008 with Bear Stearns, a troubled investment bank and brokerage with sufficient remaining collateral to support the intervention.
When private partners aren’t willing to step up, the Fed can act alone if troubled firms still have sufficient collateral. In September 2008, the Fed arranged a purely public intervention for AIG, a huge financial services company.
If remaining collateral is insufficient to support taxpayer-financed actions, the Fed under current law is obliged to let the markets decide a troubled firm’s fate. The Fed accepted this outcome with Lehman Brothers in 2008.
Why Does the Federal Reserve Intervene? [Flowchart Graphic]
According to the Dallas Fed, despite as it seems recently, The Fed doesn’t intervene lightly. There are a number of issues they take into consideration before doing so, and only do so if absolutely necessary.