Yesterday's action by the Federal Reserve marks the first time since the 1960s that the US central bank has authorised the provision of emergency finance to any financial institution other than a regulated deposit-taking bank.
As such, it marks a dramatic expansion of the Fed's role as lender of last resort for the financial system, while highlighting the shortcomings of its efforts to ensure adequate liquidity across the financial sector.
Analysts speculated the Fed could be forced to provide emergency finance to other investment banks and possibly even some hedge funds in the weeks ahead.
In a statement, the Fed said its move was intended to "promote the orderly functioning of the financial system". Fed officials said it was acting because of the "systemic issues" involved.
One official said Bear Stearns was too "interconnected" to be allowed to fail at a time when financial markets are extremely fragile.
The fifth-largest investment bank, Bear Stearns is a big factor in the credit default swaps market, a prime broker to many hedge funds, a primary dealer in the bond market and a counterparty to many leading Wall Street firms.
The Fed official said that, in normal times, the bank would have been much less likely to intervene and it was not making a policy decision to make emergency funds available to all investment banks. Other requests for rescue financing would be treated on a case-by-case basis, he said.
In practice, the Bear Stearns precedent makes it more likely such finance would be forthcoming in current market conditions, analysts said. However, the Fed will be reluctant to make emergency funds available to even a systemically important hedge fund.
A second Fed official said that providing emergency funds to an unregulated financial institution would create serious moral hazard. Moreover, even large hedge funds are not as complex as Bear Stearns in terms of their connections with the rest of the financial system.
The Fed said it was acting under section 13.3 of the Federal Reserve Act, which gives it authority to lend to any individual, partnership or corporation "in unusual and exigent circumstances".
That authority was last invoked in the 1960s and Fed officials said loans were last actually disbursed in the 1930s.
As an investment bank, Bear Stearns did not have access to the Fed's emergency lending facility, the discount window. So the Fed arranged back-to-back transactions with JPMorgan to give Bear indirect access to the window.
© 2008 Financial Times
