A nice write-up of some of the tools the Fed has at its disposal to deal with
liquidity crises:
More Ways
for the Fed to Boost Markets, by Greg Ip, WSJ: Since credit markets began to
seize up in late July, the Fed has used a variety of tools to try to restore
confidence, short of cutting its main interest rate, the target for the federal
funds rate, from its current 5.25%. Economists say it still has several tools
left, but whether the Fed would be willing to use any is an open question.
The possibilities include: lowering the discount rate further; accepting a
wider range of collateral in open market operations; permit non banks to borrow
from the discount window; create a joint lending program with Treasury to lend
to needy institutions, as it did in 1989 with thrifts; create a temporary
facility for lending against commercial paper similar to what it created in late
1999 for the century date change; and open swap lines with the European Central
Bank. A more detailed discussion follows.
Some have praised the Fed for trying to restore confidence to credit markets
without cutting the federal funds rate, which they say would create moral hazard
by bailing reckless lenders out of their bad decisions. Yet proponents of this
logic need to be wary: bending rules and conventions so much to boost particular
markets could ultimately create more moral hazard than a rate cut.
Fed vice-chairman Donald Kohn alluded to this very tradeoff in a speech last
May5. In it, he said a world in which capital markets have displaced banks as
credit intermediaries probably would have more crises requiring cuts in interest
rates, but this was "not really bad news." Cutting rates "can greatly ameliorate
the effects of market events on the economy, and … will carry less potential for
increasing moral hazard than would the discount window lending that was a
prominent feature of crisis management" when banks were more important.
Additional options the Fed has for helping markets:
1. Lower the discount rate further. Normally the discount rate, charged on
direct Fed loans to banks, sits one percentage point above the fed funds rate,
which banks charge each other for overnight loans. On Aug. 17, the Fed cut the
discount rate to 5.75% from 6.25%, leaving it just half a point above the fed
funds rate.
Many economists have argued it should fall further, to 5.5% or even to 5.25%,
equal to the fed funds rate. Banks are reluctant enough to borrow from the
discount window given the traditional stigma – in the past it was usually a last
resort for troubled banks. It's even harder for a bank to justify its use when
it also has to pay 0.5 percentage points over fed funds. Indeed, the Fed's ample
supply of additional cash via open market operations has pushed fed funds to
below 5% many days, increasing the penalty.
Fed officials have been reluctant to go that step. It needs an active Fed
funds market for its open market operations to efficiently guide interest rates
to the desired level. Putting the discount rate on a par with Fed funds could "disintermediate"
the fed funds market, that is make banks so enthusiastic about discount loans
that activity in the fed funds market dries up. The Fed does not want to
complicate life for itself when normalcy returns.
Officials also believe lengthening the term of discount window loans, to 30
days from one, should be a clear attraction at a time when banks are reluctant
to lend for more than a few days.
(Note: we use the term "banks" here to refer to all federally insured deposit
taking institutions: banks, thrifts, industrial loan companies and credit
unions.)
2. Widen the range of collateral the Fed accepts for money advanced through
open market operations. The Federal Reserve Act limits the Fed to accepting the
debt of the U.S. government or its agencies (i.e. Fannie Mae, Freddie Mac and
Ginnie Mae) as collateral for open market operations. Dealers, however, are
having no trouble financing their inventory of government and agency debt; in
general, it's asset-backed securities they need help with. But Deutsche Bank
economists in a report note that section 4.4 of the act gives the 12 reserve
banks "incidental powers" which could be construed as allowing the acceptance of
other collateral. "This was used to resolve questions regarding the authority to
offer options for repos around the century date change period, and might well
allow for a significant broadening of collateral under unusual circumstances,"
Deutsche Bank says.
The Fed thus far has taken a stricter interpretation of what it can accept
through open market operations and is reluctant to take a significantly more
liberal interpretation than some on Wall Street advocate.
3. Permit nonbanks to borrow from the discount window. Since banks are sound
and flush with cash, the logic runs, perhaps the Fed should be lending to
nonbanks, such as special purpose entities and mortgage finance companies
provided they post solid collateral. Section 13.3 of the Federal Reserve Act
permits loans to nonbanks only under "unusual and exigent circumstances," with
the approval by at least five Fed governors, when adequate funding is not
available from other sources and when failure to do so "could have significant
adverse consequences for the economy," according to the Fed. It was last done
during the Great Depression.
(A useful resource for this and related issues is the Fed's 2001 study
"Alternative Instruments for Open Market and Discount Window Operations6"
prepared when budget surpluses threatened to leave the Fed with insufficient
Treasurys to conduct open market operations.)
But this could, for the Fed, represent a troubling increase in moral hazard.
Traditionally, banks got access to the discount window and deposit insurance
because they also accepted extensive federal oversight of their activity, and
had to keep a lot of capital on hand. Opening the discount window to nonbanks
would represent an expansion of the federal safety net with unknown
consequences. And its value would be questionable; the terms under which the Fed
would lend would be so stringent that few truly distressed borrowers would meet
them. Moreover, the Fed believes that the banks should be able to channel
discount window funds to needy sectors. It has already exempted several large
banks7 from limits on certain loans to their securities dealer units as a way of
directing discount window money more directly to the securities market, and
notified banks that loans8 used to finance securities purchases would receive
favorable treatment when calculating a bank's required capital.
4. Richard Berner of Morgan Stanley says the Fed could create a "joint
lending program" as it did with the Treasury and Federal Home Loan Bank Board in
1989 to provide temporary liquidity to thrifts faced with a sharp loss of
deposits. "Only two thrifts actually borrowed," he noted, "but the program
helped restore confidence and averted potential systemic risk." But he notes it
duplicates the discount window functions, and exposes the taxpayer to loss.
5. Mr. Berner also says the Fed could create a "temporary special liquidity
facility (SLF) that would accept commercial paper collateral at a haircut to par
value." This would get liquidity to where it's needed most, he says. The Fed
created such a facility9 to lend to banks that might face funding pressure
around the century date change on Jan. 1, 2000. "By ring-fencing the operation
from ongoing open market operations and the collateral accepted for them, using
an SLF gives the Fed more protection from the risk of setting a bad precedent."
But as Mr. Berner noted, it would largely be a replication of the discount
window function.
Indeed, the Fed has already taken steps to liberalize the use of discount
loans to boost the commercial paper and asset-backed market. Significantly, on
Friday the New York Fed began notifying banks they could pledge as collateral
asset-backed commercial paper (ABCP) for which they also provided the backup
credit line. The inability of issuers to roll over maturing ABCP has been
perhaps the single biggest problem in the credit markets, and enabling banks to
take any unsold paper to the discount window could have a major impact. This
could be of particular appeal to European banks with branches in New York as
they have faced the greatest pressure to finance maturing ABCP. Data to be
released next Thursday will show if this led to a big increase in discount
window loans.
6. Open swap lines with the European Central Bank. Many European banks face
pressure to provide dollar funding for maturing commercial paper programs, but
the European Central Bank supplies euros in conducting monetary policy. This is
one reason Libor, charged largely on short-term, unsecured dollar between
European banks, is so high. The Fed could create a swap line with the ECB,
giving it the ability to lend dollars in return for the Fed getting the ability
to lend an equivalent amount of euros. The Fed opened several such swap lines
after the Sept. 11, 2001 terrorist attacks.
Such a swap line would provide some relief but would likely be done only at
the behest of the ECB; as such, it is of limited use to the Fed in offsetting
domestic pressures.