WASHINGTON — In the past two weeks, the Federal Reserve, long the guardian of the nation’s banks, has redefined its role to become protector and overseer of Wall Street.
With its March 14 decision to make a special loan to Bear Stearns and a decision two days later to become an emergency lender to all of the major investment firms, the central bank abandoned 75 years of precedent under which it offered direct backing only to traditional banks.
Inside the Fed and out, there is a realization that those moves amounted to crossing a Rubicon, setting the stage for deeper involvement in the little-regulated markets for capital that have come to dominate the financial world.
Leaders of the central bank had no master plan when they took those actions. They were focused on the immediate crisis in world financial markets.
But they now recognize that a broader role may be the result of the unprecedented intervention and are being forced to consider whether it makes sense to expand the scope of their formal powers over the investment industry.
“This will redefine the Fed’s role,” said Charles Geisst, a Manhattan College finance professor. “We have to realize that central banking now takes into its orbit everything in the financial system in one way or another. Whether we like it or not, they’ve re-created the financial universe.”
The Fed has made a special lending facility available to large investment banks for at least the next six months. Even if that program is allowed to expire this fall, the Fed’s actions will have lasting impact, economists and Wall Street veterans said.
Major investment banks might be willing to take on more risk, assuming the Fed will be there to bail them out. But Fed leaders concluded that because the rescue caused huge losses for Bear Stearns shareholders, other banks would not want to risk that outcome.
More worrisome, in the view of top Fed officials: The parties that do business with investment banks might be less careful about monitoring whether the bank will be able to honor obscure financial contracts if they assume the Fed will back up those contracts. That would eliminate a key form of self-regulation for investment banks.
“It has wrought changes far more significant than they were probably thinking about at the time,” said Vincent Reinhart, a resident fellow at the American Enterprise Institute who was until last year a senior Fed staffer.
