By Craig Torres and Steve Matthews
May 13 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said financial markets remain unsettled and the central bank will increase its auctions of cash to banks as needed.
While markets have improved, they remain ``far from normal,'' Bernanke said today in the text of a speech to an Atlanta Fed conference at Sea Island, Georgia. ``We stand ready to increase the size of the auctions if further warranted by financial developments.''
Bernanke's comments contrast with those by Treasury Secretary Henry Paulson and Wall Street leaders including Vikram Pandit, chief executive officer of Citigroup Inc., who say the worst of the credit crisis is over. The Fed chief said it will take ``some time'' for financial firms to resolve the crisis by raising new capital and strengthening their management of risk.
The flight from risk since August has made financial institutions reluctant to lend to each other, driving up banks' borrowing costs. The central bank has made its own balance sheet available to both banks and bond dealers through three new lending tools, and an expansion of existing programs.
Bernanke said the Fed's efforts have yielded ``some improvement,'' while also noting that the steps raise questions regarding moral hazard, or protecting those who take on risk.
The central bank's extension of the federal safety net raised questions about whether the government should now use taxpayer money to stem mortgage foreclosures, the primary cause of market distress.
``A central bank that is too quick to act as a liquidity provider of last resort risks inducing moral hazard,'' Bernanke said. The belief that the Fed is always standing by would give ``financial institutions and their creditors less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.''
Bernanke didn't discuss the path of interest rates or the outlook for the economy. The Federal Open Market Committee last month cut its benchmark rate by a quarter point to 2 percent and signaled it's ready for a pause after seven reductions.
Cleveland Fed President Sandra Pianalto said in a speech in Paris today that consumer prices are rising faster than she'd like and that inflation is a ``key risk'' to the economic outlook. Pianalto is a voter on the FOMC this year.
Kansas City Fed President Thomas Hoenig, San Francisco Fed chief Janet Yellen, Richard Fisher of the Dallas Fed and Charles Evans from Chicago are also scheduled to speak today. Bernanke spoke via satellite.
The Fed chairman said federal banking agencies are trying to address moral hazard through a review of ``policies and guidance regarding liquidity risk management to determine what improvements can be made.''
``Future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing,'' Bernanke said. ``Ultimately, market participants themselves must address the fundamental sources of financial strains -- through deleveraging, raising new capital, and improving risk management.''
That process will take time, he added, noting that ``once financial conditions become more normal, the extraordinary provision by the Federal Reserve will no longer be needed.''
The Fed announced May 2 that it would boost the Term Auction Facility, or TAF, to $150 billion per month from $100 billion, the third increase since the program began in December.
Premiums in term dollar funding markets still ``remain abnormally high,'' Bernanke said. ``Funding pressures have also been evident in the strong participation at recent TAF auctions even after the recent expansion in auction sizes.''
The gap between three-month Treasury bill yields and three- month dollar-denominated loans in London, narrowed to 89 basis points yesterday, the least since Feb. 20. A basis point is 0.01 percentage point.
On March 11, the Fed announced the Term Securities Lending Facility, which allows primary dealers to swap up to $200 billion of AAA rated commercial and residential mortgage-backed securities and other collateral for the Fed's holding of Treasury securities for up to 28 days. The facility was aimed at helping dealers finance mortgage bonds.
The FOMC expanded the facility May 2 to include AAA rated asset-backed securities. The decision followed two separate requests by groups of Senate and House members that the Fed accept debt backed by student loans under the program.
``The Federal Reserve has had to innovate in large part to achieve what other central banks have been able to effect through existing tools,'' Bernanke said.
Bear Stearns Loan
Bernanke also repeated his defense of the Fed's rescue of Bear Stearns Cos. in March. The central bank invoked emergency authority on March 16 to start direct lending to government bond dealers, and arranged $30 billion in financing to facilitate the Bear Stearns takeover by JPMorgan Chase & Co.
``A bankruptcy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral,'' Bernanke said in his speech. ``Given the illiquidity of markets, those creditors and counterparties might have sustained losses.''
The Bear Stearns loan has been criticized by some former officials and Fed watchers, who said the central bank shouldn't substitute its own loans for fleeing creditors when institutions become insolvent.
Vincent Reinhart, former director of the Fed Board's Division of Monetary Affairs, called the Bear rescue the ``worst policy decision in a generation.''
Creditors also now perceive a wide safety net under investment banks, which the Fed doesn't supervise.
The cost of default protection on Merrill Lynch & Co. debt fell to 1.58 percentage point yesterday from 3.3 percentage points March 14, CMA Datavision's credit-default swap prices show.
Hoenig said May 6 the central bank's decisions are ``likely to weaken market discipline.''