And I quote...

From the most recent speech of Fed governor Mishkin...

"Our understanding of the sources of systemic risk immediately suggests three general principles for operating as an effective lender of last resort: (1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently."

Perhaps I am being overly critical of the role of central banks, but I would like to point out that The Federal Reserve and other central bankers around the globe have not been following their own standards.

1) While they have injected billions in liquidity, it remains to be seen whether confidence has been restored. The $40 billion Canadian ABCP market is still locked up. UK banks without credit exposure to US Subprime are failing and depositors are running for the exit. The largest deposit banks in the US (Citi, BoA, Wachovia, etc) have borrowed $500 million apiece to funnel to their investment banking arms. What confidence?

2) The last several Fed cuts in the interest rate have fueled asset bubbles rather than encourage adequate prudential supervision. In fact, it can be argued that had Greenspan not cut interest rates to 1% and held it there for too long, we would not be currently mired in a housing asset bubble of epic proportions.

3) Infrequent - If we take the word at its literal translation, it would mean that the lender of last resort should not make 'frequent' forays into the credit markets. In the past several weeks, central bankers have injected billions - billion with nine trailing zeros - into the credit markets. And every week, they have to lend more. Just this week, the US Federal Reserve has lowered the collateral standards to include mortgage securities.

So what does this all mean?

In my opinion, either the central bankers are stupid, or they are trying desperately to prop up the markets in hopes that the gummed up markets will loosen themselves in time. I prefer to believe the latter.

If the credit markets are still locked up, then we can reasonably expect the next several months to be extremely volatile. Either the other shoe falls, or things calm down enough for normal lending to occur. In either scenario, it will be an interesting period indeed.

-Jason