The Fed’s Competition: The Real Lenders of Last Resort

It is well known that the Fed injected massive amounts of liquidity into the financial system during the 2007-2009 financial crisis.   Far less well known is that the Fed was not the only place banks obtained government-backed liquidity when market sources first ran dry.  Moreover, during the early stages of the Crisis, the Fed was not even the primary source of government-backed liquidity.  As I reveal in a new paper forthcoming in the Cornell Law Review, and available here, instead of going to the Fed’s discount window, banks increased their reliance on two other forms of government-backed liquidity.  First, banks dramatically increased their use of secured loans from the Federal Home Loan Bank system, a little known government-sponsored enterprise that ballooned in size to over $1 trillion during the crisis.  Second, when banks got into trouble, they used the lure of exceptionally high interest rates to retain and attract new insured deposits.  As a result, these programs effectively served as alternatives to the Fed’s discount window—standing sources of government-backed liquidity that banks could access when market sources of liquidity became scarce or too costly.

Neither of the alternative discount windows the paper identifies were designed to play this role.  Both the Federal Home Loan Banks and federal deposit insurance are byproducts of the Great Depression.  The Federal Home Loan Banks, like the other GSEs, Fannie Mae and Freddie Mac, were created to make it easier for Americans to realize the dream of home ownership.  Deposit insurance was intended to protect small, individual depositors from the losses they otherwise would face when their bank failed and to discourage bank runs.  This paper shows that because these programs were not designed to serve as alternatives to the discount window, they are not structured to address the moral hazard and other issues that result.  Moreover, their existence gives rise to a range of other policy challenges.  Transparency and accountability are compromised, as is the leverage that the Fed enjoys in its lender-of-last resort operations.

Yet the existence of alternative discount windows is not solely a story of market innovations and legislative lapses resulting in a suboptimal regime.  The recent crisis also made clear that there is a stigma associated with using the Fed’s discount window.  That stigma can cause banks to borrow less than would be socially optimal.  Moreover, because of the rise of the shadow banking system and other changes in the structure of the financial system, the discount window is not well-suited to meet the range of liquidity shortfalls that can plague a modern financial system.  By increasing the amount of government-backed liquidity entering the system during periods of distress, the operation of the alternative discount windows may have some benefits.

Once we recognize that banks are using these programs as alternative discount windows, and there are both benefits and drawbacks that arise as a result, the question becomes, where do we go from here.  The paper suggests that particularly in light of data showing that troubled banks are more likely than healthy banks to rely on the alternative discount windows, reform is warranted.  The type of change required will vary by program, but the paper proposes a number of ways that the underlying programs could be modified to reduce moral hazard and improve coordination and accountability.  The paper also calls attention to the need for further study of when and how a lender of last resort should respond to the types of liquidity shortages that can arise in a modern financial system.

The full article, which is forthcoming in the Cornell Law Review, is available here.