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.