Fed officials split on Fed's role as market savior

NEW YORK (Reuters) - Federal Reserve policymakers continue to debate the extent of the central bank's role as a safety valve for battered financial markets and troubled banks, according to comments by Fed officials on Thursday.

Donald Kohn, the Fed's influential vice-chairman, said in Congressional testimony that policy-makers stood ready to act again if needed to shield the financial system from the failure of a major financial institution.

Kohn defended the central bank's role in funding JP Morgan's emergency buyout of investment bank Bear Stearns in March, but he declined to comment on the health any other specific firms.

"Our judgment was that had Bear Stearns BSC.N been allowed to walk into bankruptcy court, that would have disrupted the financial system and had very serious effects on the economy," Kohn told the Senate Banking Committee.

But two of his colleagues, Richmond Fed President Jeffrey Lacker and his Philadelphia counterpart Charles Plosser, seemed leery of such actions, fearing they might encourage excessive risk taking and foment future crises.

The comments come as investors worry about the possibility that investment bank Lehman Brothers LEH.N could run into the liquidity problems that brought Bear Stearns to its knees, with speculation rife about a possible acquisition of Lehman by another major bank.

"Policy interventions in financial markets run the risks of increasing moral hazard and inhibiting efficient price discovery," Plosser told students and faculty at New York University's Stern School of Business.

"Moreover, interventions intended to quell instability can, by creating moral hazard, actually make instability more severe in the long run."

To avoid such pitfalls, Plosser said the central bank should develop clear benchmarks for when a particular situation might truly constitute a systemic risk.

"Specifying in advance the conditions or states of the world under which the central bank will lend is an essential first step," he said.

Lacker, from the Richmond Fed, shared some of the same concerns, indicating he was worried that moves aimed at the short-term alleviation of borrowing strains could sow the seeds for future crises.

"The danger is that the effect of recent credit extension on the incentives of financial market participants might induce greater risk taking," Lacker told a business group.

This "in turn could give rise to more frequent crises, in which case it might be difficult to resist further expanding the scope of central bank lending."

In a separate telephone interview with Reuters, speaking of Bear Stearns demise, said, "I don't question the decision that was made. It was an excruciating choice, an excruciating dilemma, that they faced. But a system that puts us in that position needs some review."

GROWTH RISKS SEEN RECEDING

Lacker was alone among the day's speakers to address the state of the economy directly, saying the chances of a prolonged economic downturn had diminished, but that inflation was once again rearing its head.

"As time has gone on, that risk of a sharper contraction has definitely receded in my mind," Lacker said, speaking from London. "At the same time ... overall inflation has come in uncomfortably high."

Plosser, the Fed's most vocal inflation hawk, did not tackle the issue of current price rises. But he reiterate his oft-stated belief that maintaining price stability is the primary function of the central bank, adding that low inflation was also the best way to ensure sustainable economic growth, the other half of the Fed's dual mandate.

TWEAKING THE MODELS

Plosser spent much of his remarks discussing the shortcomings in the models financial institutions use to assess risks, defending the benefits of new and more complex financial products but acknowledging that there was room for improvement in the way the potential for defaults is gauged.

He noted that predicting the behavior of consumer loans was made difficult by a relatively limited amount of available historical data, adding that the central bank should play a key role in beefing up techniques for risk measurement.

"While there have been enormous advances in this type of modeling over the last two decades, there are still notable weaknesses," Plosser said.

"Therefore, improving these modeling methodologies and increasing transparency, as well as obtaining better measures of model uncertainty, will be factors in improving the functioning of certain financial markets," he said.

"The Federal Reserve and other banking regulators have been devoting more resources to looking at this modeling apparatus for the purpose of assessing bank risk management."

(Reporting by Pedro Nicolaci da Costa)