We have covered the three major tools the Fed has to control the money supply: open market operations, lending, and the payment of interest on reserves. In times of crisis, the Fed can and has gone beyond these tools to address problems with the financial system that extend beyond banks.

In times of crisis, for example, the Fed has decided that its lender of last resort function is not restricted to traditional banks alone. In March 2008, the Fed made extensive loan guarantees to JP Morgan, which was in the midst of purchasing the failing company of Bear Stearns, a financial institution but not a bank in the traditional sense. In fact, Bear Stearns, which fell under the legal definition of “investment bank,” was regulated by the Securities and Exchange Commission (SEC). The Fed’s view was that Bear Stearns owed a lot of money to banks (true), so if Bear Stearns failed, a lot of banks would fail too, thus causing the money supply to plummet. The Fed therefore thought that it needed to prevent Bear Stearns from shutting down to prevent much bigger problems. The Fed probably had a reasonable worry and it acted promptly to address that worry. Nonetheless, the market has since been wondering what exactly are the powers and duties of the Fed since it acted outside of its traditional legal mandate. The Fed even assumed a majority ownership stake in the insurance company American International Group (AIG), and in effect bailed out the company, under the rationale that AIG owed a lot of money to banks. The fnancial crisis of 2007-2008 led to a true blurring of the functions of the Fed, and it is widely recognized that a more comprehensive redefinition of the Fed’s responsibilities is needed.

The general issue in the Bear Stearns case and also the AIG case is called systemic risk. Systemic risk simply means that the failure of one financial institution can bring down other institutions as well, just as if a chain of dominoes were collapsing. Do you know the old joke: “If you owe your banker a million dollars and can’t pay, you have a problem. If you owe your banker a billion dollars and can’t pay, your banker has a problem.” Preventing the spread of systemic risk is one of the most important things the Fed does.

There is, however, a problem. Whenever the Fed acts to limit systemic risk, it insulates at least some banks from the financial consequences of their bad decisions. For instance, a bank that lent too much money to Bear Stearns now knows it doesn’t have to worry so much the next time around because the Fed will probably step in to bail them out. When individuals or institutions are insured, they tend to take on too much risk—incentives matter—and economists call this the problem of moral hazard. A homeowner who is insured, for example, has a reduced incentive to install smoke alarms, which is one reason why insurance companies give discounts to those who do install alarms. In the case of banks, the longer-run consequence of moral hazard is that banks will be less careful about their financial commitments. Limiting systemic risk while checking moral hazard is the fundamental problem the Fed faces as a regulator of bank safety.

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When it comes to the Fed’s lender of last resort function, it can be said that we live in interesting times. A great deal has been changing in the last few years and those changes probably are not over. The general tendency has been for the Fed to become much more active and to assume greater powers in the case of emergency and perhaps during normal times as well.