Reforming Last-Resort Lending: The Flexible Open Market Alternative

Abstract

I offer a plan for supplying liquidity during financial emergencies that altogether dispenses with direct central-bank lending. The plan instead relies upon flexible open market operations to supply liquidity in amounts needed and to firms most in need of it, where the necessary flexibility is achieved (1) by allowing all sound depository institutions, as well as existing Primary Dealers, to participate in Fed security purchases and sales; (2) by switching from a Treasuries only open-market framework to one that allows counterparties to bid for Fed funds using the full set of securities traditionally eligible as collateral for Fed discount loans; and (3) by replacing conventional auctions with Product Mix auctions, like those now employed by the Bank of England, so competitive bidding takes place on price and collateral-quality dimensions simultaneously. These arrangements should collectively suffice to render direct central bank lending, whether broad based or to specific markets and firms, unnecessary.