Contacts: Steven Schwarcz, 919-613-7060, schwarcz@law.duke.edu; Melinda Vaughn, 919-613-7034, vaughn@law.duke.edu  

DURHAM, North Carolina, Sept. 18 /Standard Newswire/ -- At its meeting today, the Federal Reserve is expected to address the subprime mortgage crisis by again cutting the interest rate it charges banks. But the Fed needs to take a broader approach when addressing financial problems that threaten to seriously damage the economy, says a Duke University law and business professor.

"In the subprime crisis, the Federal Reserve reacted by cutting the discount rate, the interest rate it charges banks to borrow," said Steven Schwarcz, founding director of the Duke Global Capital Markets Center. "The problem, however, is that these types of monetary-policy approaches impact banks but do not directly impact financial markets -- and it is markets, not banks, that are at risk in the current crisis."

The subprime mortgage crisis is an example of what can trigger systemic risk -- the risk that an economic shock, such as market panic or institutional failure, may trigger a domino effect, causing the failure of a chain of markets or institutions, said Schwarcz, the Stanley A. Star Professor of Law and Business at Duke.

Systemic risk requires a governmental solution because individual market participants do not have sufficient incentives to limit risk-taking, he said. One solution is to create a "lender of last resort," a private or public entity that would stabilize collapsing markets by purchasing securities in those markets.

"A lender of last resort need not burden taxpayers," Schwarcz noted. "If governmental, the lender of last resort could finance itself either by charging premiums to market participants -- similar to the approach taken by the FDIC when insuring deposit accounts -- or by charging market-rate interest on loans or taking market discounts on purchases."

Exactly who the lender of last resort would be should be determined by a careful consideration of future risks, Schwarcz said. As markets become increasingly interdependent around the globe, for example, a multinational entity may be needed. The lender of last resort might also be a private entity.

"All things considered, however, the Federal Reserve is the most logical entity in the U.S. to play the role of lender of last resort, at least domestically," Schwarcz said. "The Fed may need to obtain additional legal authority to do so, but this should not be difficult to accomplish."

"Whatever the solution, it's clear that the Federal Reserve needs to broaden its thinking to protect against the real possibility of a systemic collapse of our increasingly interconnected financial markets and the dire consequences that would bring."

Before joining Duke, Schwarcz was a law firm partner and practice group chairman, representing many of the world's leading banks and other financial institutions in structuring innovative capital market financing transactions, both domestic and international.