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For immediate release: November 25, 2008

Dallas Fed Publication Examines Moral Hazard During Financial Crises

DALLAS—The Federal Reserve would be unable to deal with threats to the financial system if it tried to eliminate moral hazard, according to the latest issue of the Federal Reserve Bank of Dallas' Economic Letter.

"Fed Intervention: Managing Moral Hazard in Financial Crises" examines the Fed's key actions during three crises: the collapse of Long-Term Capital Management in 1998, the aftermath of the Sept. 11, 2001, terrorist attacks and the current global financial crisis.

The article's authors are executive vice president and director of research Harvey Rosenblum, financial analyst Danielle DiMartino, research analyst Jessica Renier and senior economics writer Richard Alm.

During the crises cited, when intervention was the only option, the Fed made decisions that minimized micro moral hazard—that is, the benefit to any specific firm or industry. It did so because of concern about the overall financial system, the authors find.

Eliminating moral hazard would harm the Fed's ability to fulfill its most important legal mandates: full employment and sustainable economic growth, price stability, and banking and financial system stability.

"Like it or not, central bankers face the reality that managing moral hazard is an inescapable part of their job description," the authors write.

The Fed rarely intervenes in financial markets or a single financial institution, the authors note.

"In the current financial crisis' first year, the Fed's response has been measured, reflecting the commitment to doing only what's necessary," the authors write.


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