Emergency Lending Facilities Research Articles

Mexico

The Mexican financial authorities strengthened the financial safety net since the last FSAP and need to continue and accelerate enhancements. Recovery and resolution plans are in place for all commercial banks, systemic banks are required to increase their loss absorbency complementing the critical Basel III reforms that the authorities have advanced, and the authorities progressed preparations for using the bridge bank tool, signed cooperation agreements with all major home jurisdictions of the Mexican systemic banks, clarified the emergency lending facilities including to banks in resolution, and improved the depositor payout process. Yet, accelerated enhancements are necessary, including by further improving the credibility and feasibility of banks’ financial contingency arrangements, removing impediments to banks’ resolvability and the use of the bridge bank and purchase and assumption transaction resolution tools, expanding the resolution regime’s remit to financial holding companies, and reinforcing the resolution and deposit insurance agency’s governance, autonomy, and resources.

The Federal Reserve's response to the COVID-19 contraction: An initial appraisal.

We provide an initial assessment of the Federal Reserve's policy response to the COVID‐19 contraction. We briefly review the historical episode and consider the standard textbook treatment of a pandemic on the macroeconomy. We summarize and then evaluate the Fed's monetary and emergency lending policies through the end of 2020. We credit the Fed with promoting monetary stability while maintaining that it could have done more. We argue that the Fed could have achieved stability without employing its emergency lending facilities. Although some facilities likely helped to promote general liquidity, others were primarily intended to allocate credit, which blurs the line between monetary and fiscal policy. These credit allocation facilities were unwarranted and unwise.

LESSONS FOR THE FED FROM THE PANDEMIC

The Covid-19 pandemic greatly increased the scope and power of the Federal Reserve. The Fed created a number of new emergency lending facilities, which allowed it to make off-balance sheet loans and buy the debt of corporations and municipalities through special purpose vehicles backstopped by the Treasury under the CARES Act. Meanwhile, the Fed's large-scale asset purchase program, known as quantitative easing (QE), was put on steroids after the pandemic struck in March 2020. The Fed has been purchasing longer-term Treasuries and mortgage-backed securities amounting to $120 billion per month, pushing the size of its balance sheet to an astonishing $7 trillion.Of course, the pandemic and lockdowns, which put the economy in a downward spiral, justified pumping liquidity into the financial system. But the shift toward allocating credit and the drift into fiscal policy have put the Fed's independence and credibility at risk. Indeed, those actions have set a precedent for the future, making it difficult for the Fed to normalize monetary policy and adhere to its primary function of providing sound money and a stable growth of nominal income.This conference's focus is on digital currency. In my remarks today, I will paint with a broader brush and briefly discuss the lessons I think the Fed can learn from the pandemic, including why it is important to leave entrepreneurs free to experiment with digital currencies and why any credible monetary system ultimately needs to be based on a genuine rule of law. I shall begin by arguing that while Covid-19 has been costly, both in terms of human and economic losses, it has provided for deregulation and innovation that will benefit society.

The Federal Reserve's Response to the COVID-19 Contraction: An Initial Appraisal

We provide an initial assessment of the Federal Reserve's policy response to the COVID-19 contraction. We briefly review the historical episode and consider the standard textbook treatment of a pandemic on the macroeconomy. We summarize and then evaluate the Fed's monetary and emergency lending policies through the end of 2020. We credit the Fed with promoting monetary stability while maintaining that it could have done more. We argue that the Fed could have achieved stability without employing its emergency lending facilities. Although some facilities likely helped to promote general liquidity, others were primarily intended to allocate credit, which blurs the line between monetary and fiscal policy. These credit allocation facilities were unwarranted and unwise.

Fighting Crises with Secrecy

How does central bank lending during a crisis restore confidence? Emergency lending facilities that are opaque (in that names of borrowers are kept secret) raise the perceived average quality of bank assets in the economy, creating an information externality that prevents runs. Stigma (the cost of a bank’s participation at the lending facility becoming public) is desirable to implement opacity as an equilibrium outcome, as no bank wants to reveal its participation status. The central bank’s key policy instrument for limiting the use of lending facilities while maintaining secrecy is the haircut applied to bank assets used as collateral. (JEL D83, E52, E58, E63, G01, G21)

Liquidity from two lending facilities

We examine how the threat of disclosure (stigma) changes the quality of banks that approach emergency lending facilities. We study a financial crisis where two confidential facilities were available to banks. Unexpectedly, a partial list of bank names from one facility was published, suddenly stigmatizing that facility. We find that the composition of banks that approached each facility changed, where the newly stigmatized facility attracted weaker banks that maintained smaller liquidity buffers, while the alternative confidential facility attracted both weaker and stronger banks. Our results shed light on how stigma prevents regulators from reaching many banks to inject critical liquidity into the banking sector during a crisis.

The Financial Response to the COVID-19 Pandemic

We are living through extraordinary times as the United States has struggled to deal with the global COVID-19 pandemic, and as of the writing of this paper, we remain in the midst of the crisis. We still do not know what the full economic and financial consequences of the pandemic will be, but they are likely to persist for an extended period, as many people are unlikely to return to normal work or consumption patterns soon, and household and business defaults are likely to increase and negatively affect the financial sector. This paper, written to assist faculty in teaching about the pandemic, focuses on key actions taken by the financial regulators in response to the crisis so far, giving a detailed summary of the actions taken by the Federal Reserve, the Treasury Department, and Congress. We discuss the Federal Reserve’s monetary policy actions, emergency lending facilities, and supervisory forbearance by the federal banking agencies. We also provide a summary of financial provisions of the CARES Act, including an analysis of the Paycheck Protection Program. We explore a number of central themes already emerging, including the blurry line between monetary policy and fiscal policy. We also highlight the fact that unlike the Financial Crisis of 2008, today’s economic crisis is caused by the failure to take sufficient public health actions to contain a global pandemic, not poor policy and risk choices in the financial markets; the fact that the crisis is caused by a public health failure poses unique problems for economic and financial policymakers in crafting responses.

The Quality of Banks at Stigmatized Lending Facilities

When the names of banks that borrow from an emergency lending facility are inadvertently leaked, the facility may become stigmatized. We examine how the quality of the borrowing pool of banks changed when stigma was unexpectedly introduced at a once confidential lending facility during the Great Depression. This facility experienced a compositional shift in the quality of its borrowing pool, where only weaker banks that maintained smaller liquidity buffers used the facility, while an alternative confidential facility attracted stronger banks. Our results shed light on how the design of lending facilities may attract certain types of banks.

BANK CAPITAL, THE ANNOUNCEMENT OF THE FEDERAL RESERVE'S TERM AUCTION FACILITY, AND BANK BORROWING DURING THE FINANCIAL CRISIS OF 2007–2008

AbstractDuring the financial crisis of 2007–2008, the Federal Reserve System created emergency lending facilities to address the liquidity problem in financial markets and alleviate the stigma attached to borrowing from its traditional lending facility, the discount window. The most important and commonly used facility was the Term Auction Facility (TAF) announced December 12, 2007. Using event‐study methodology, we find that stock prices of TAF participating banks experienced a significant −2.84% average cumulative abnormal return around the announcement date. The negative abnormal returns correlated with the peak loan balances reached on average 416 days after the announcement.

Managing stigma during a financial crisis

How should regulators design effective emergency lending facilities to mitigate stigma during a financial crisis? I explore this question using data from an unexpected disclosure of partial lists of banks that secretly borrowed from the lender of last resort during the Great Depression. I find evidence of stigma in that depositors withdrew more deposits from banks included on the lists in comparison with banks left off the lists. Overall, the results suggest that an emergency lending facility that never reveals bank identities would mitigate stigma.

Managing Stigma During a Financial Crisis

Abstract How should regulators design effective emergency lending facilities to mitigate stigma during a financial crisis? I explore this question using data from an unexpected disclosure of partial lists of banks that secretly borrowed from the lender of last resort during the Great Depression. I find evidence of stigma in that depositors withdrew more deposits from banks included on the lists in comparison with banks left off the lists. Overall, the results suggest that an emergency lending facility that never reveals bank identities would mitigate stigma.

Reconsidering Central Bank Lending of Last Resort

Central banks serve many key roles in financial markets and economies. One of their most important tasks consists of lending of last resort. When standard sources of funding dry up, banks and increasingly other financial institutions expect central banks to replace conventional lenders. Changed realities in financial markets, however, challenge central banks to reconsider the terms traditionally applied to their emergency lending facilities. The Bagehot dictum, providing the elementary criteria for last resort lending, must be reassessed in light of today’s large, interconnected financial markets in which banks pose enormous threats to financial stability and transposition of monetary policy has become more complicated for central banks. This article analyses these issues from the perspective of lending of last resort by the US Federal Reserve System (‘Fed’), the central banks of the Eurozone (‘Eurosystem’) and the Bank of England. It argues in favour of robust and reliable lending criteria and consequently the elimination of the principle of constructive ambiguity and a flexible application of all other traditional lending requirements. Central banks do not operate in a legal vacuum, but the legal provisions on which such lending relies have been given little attention. The article breaks with this tradition, focusing on the Eurosystem whose legal framework leaves important issues unaddressed. It calls for an explicit mandate of financial stability for the Eurosystem that prescribes the circumstances under which financial stability takes priority over the price stability objective.

Lobbying, political connections and emergency lending by the Federal Reserve

This paper tests whether the political connections of banks were important in explaining participation in the Federal Reserve’s emergency lending programs during the recent financial crisis. Our multivariate tests show that banks that were politically connected—either through lobbying efforts or employment of politically connected individuals—were substantially more likely to participate in the Federal Reserve’s emergency loan programs. In economic terms, participation in these programs was 28–36% more likely for banks that were politically connected than for banks that were not politically connected. In our final set of tests, we attempt to identify a proper explanation for this peculiar relationship. While a broad literature speaks of the moral hazard associated with receiving bailouts, we test whether another type of moral hazard exists in the period preceding the bailout. In particular, we argue that, to the extent that political connections act as synthetic insurance, banks may have engaged in more risky behavior that lead them to the Fed’s emergency lending facilities. Tests seem to confirm this explanation.

Managing Stigma during a Financial Crisis

How should regulators design effective emergency lending facilities to mitigate stigma during a financial crisis? I explore this question using data from an unexpected disclosure of partial lists of banks that secretly borrowed from the lender of last resort during the Great Depression. I find evidence of stigma in that depositors withdrew more deposits from banks included on the lists in comparison with banks left off the lists. However, stigma dissipated for banks that were revealed earlier after subsequent banks were revealed. Overall, the results suggest that an emergency lending facility that never reveals bank identities would mitigate stigma.

Clearinghouse loan certificates as interbank loans in the United States, 1860–1913

Before the founding of the Federal Reserve, bank clearinghouse associations served as an emergency lending facility during the National Bank Era (1863–1913). This article clarifies the operation of clearinghouse loan certificates during panic periods. If clearinghouse loan certificates do not circulate among the general public, then they bear similarities to interbank loans among clearinghouse member banks. In general, the central clearinghouse organization does not act alone as a lender of last resort to make loans from the central clearinghouse to individual member banks.

Valuation of Government Policies and Projects

Governments play a central role in the allocation of capital and risk in the economy. Evaluating the cost to taxpayers of government investments requires an assumption about the government's cost of capital. Governments often take their borrowing rate to be their cost of capital, which implicitly treats the market risk associated with their activities as having no cost to taxpayers. This article reviews the theoretical and practical rationale for treating market risk as a cost to governments, presents an interpretive review of the growing literature that applies the concepts and tools of modern finance to evaluating the costs of government policies and projects, and suggests directions for future research. Examples considered include deposit insurance, Fannie Mae and Freddie Mac, the Federal Reserve's emergency lending facilities, student loans, real infrastructure investments, and public pension plans.

Did the Market Signal Impending Problems at Northern Rock? An Analysis of Four Financial Instruments

AbstractThe academic literature has regularly argued that market discipline can support regulatory authority mechanisms in ensuring banking sector stability. This includes, amongst other things, using forward‐looking market prices to identify those credit institutions that are most at risk of failure. The paper's key aim is to analyse whether market investors signalled potential problems at Northern Rock in advance of the bank announcing that it had negotiated emergency lending facilities at the Bank of England in September 2007. A further aim of the paper is to examine the signalling qualities of four financial market instruments (credit default swap spreads, subordinated debt spreads, implied volatility from options prices and equity measures of bank risk) so as to explore both the relative and individual qualities of each. The paper's findings, therefore, contribute to the market discipline literature on using market data to identify bank risk‐taking and enhancing supervisory monitoring. Our analysis suggests that private market participants did signal impending financial problems at Northern Rock. These findings lend some empirical support to proposals for the supervisory authorities to use market information more extensively to improve the identification of troubled banks. The paper identifies equities as providing the timeliest and clearest signals of bank condition, whilst structural factors appear to hamper the signalling qualities of subordinated debt spreads and credit default swap spreads. The paper also introduces idiosyncratic implied volatility as a potentially useful early warning metric for supervisory authorities to observe.

Indirect price increases and real wages during world war II

How should regulators design effective emergency lending facilities to mitigate stigma during a financial crisis? I explore this question using data from an unexpected disclosure of partial lists of banks that secretly borrowed from the lender of last resort during the Great Depression. I find evidence of stigma in that depositors withdrew more deposits from banks included on the lists in comparison with banks left off the lists. Overall, the results suggest that an emergency lending facility that never reveals bank identities would mitigate stigma.