8. History of Lender of Last Resort in the United States

While the Federal Reserve took heroic and creative measures during the 2008 crisis to expand its LLR function, particularly to extend credit to the nonbank sector, ideally these LLR powers should be clearly defined and deployed in advance. There should be no doubt that the weapons will be used if necessary. The ex ante credibility of LLR prevents a panic in the first place, thus obviating the need to actually provide liquidity. Much as Mario Draghi, President of the European Central Bank (“ECB”), committed to do “whatever it takes to preserve the euro,”1 a central bank as lender of last resort can commit to do whatever it takes to provide necessary liquidity to the financial system, subject to the general constraint that it will only loan against good collateral to solvent institutions.2

In 1797, Sir Francis Baring classified the Bank of England as the “the dernier resort,” constituting the probable first mention of the concept of “lender of last resort.”3 In 1873, Walter Bagehot authored Lombard Street: A Description of the Money Market4 following the failure of Overend, Gurney, and Company, a discount bank.5 With this crisis as a framework, Bagehot offered his famous dictum for an effective lender of last resort: the central bank should “lend early and freely … to solvent firms, against good collateral, and at ‘high rates.’”6 Bagehot argued that this policy would allay public concerns and preemptively avoid credit access issues.7 Bagehot subsequently examined why the Bank of England should and could act as an effective lender of last resort. He asserted that the Bank of England’s liquid holdings, gold reserves, and public duties positioned the Bank of England as the prototypical lender of last resort.8 In the 1800s and early 1900s, Bagehot and his lender-of-last-resort policies were effectively applied not only in England but also in Canada, France, and Germany.9 However, the Bank of England could never confirm which banks were solvent, as it had no ability to inspect their books. The Bank of England could likely only examine their balances at the Bank of England itself, and observe market prices for their debt instruments in secondary markets. Hence it could not definitively determine bank solvency.10

The presence of a strong lender of last resort is paramount to financial stability. As further developed below, the need for such a lender was the reason the Federal Reserve System was created. In my view, a strong and independent LLR is even more important than a strong and independent manager of monetary policy. A bad LLR policy could destroy our country in weeks, forcing huge losses of wealth and strong motives for revolt. Bad monetary policy is to be avoided but it can be corrected over a much longer horizon, as illustrated by Paul Volcker’s correction of the bad monetary policy of prior Fed Chairman Miller. It took Volcker at least four years to right the ship.11 Inflation was around 9 percent when Volcker took office in August 1979. It increased to 11 percent in 1980, before declining to 5 percent in 1983 after Volcker’s exceptional measures.12 While the Bank of England was created in 1694 and the Bank of Japan was created in 1882, the United States did not have a central bank until 1913, following the banking panic of 1907. Part of the reason that it took so long has to do with the history of the First and Second National Banks. Although these two banks were not central banks, they were federal banks that could loan to any borrowers, commercial as well as financial institutions, and they ultimately foundered on the idea that it was improper for the US government to make loans to the private sector. It is important to understand this history not only because it explains why it took so long to create the Fed but also because the populist objections to any kind of government bank (even one that lends only to financial institutions) are still with us today, and indeed are the main factor why the Fed is now such a weak lender of last resort.

8.1  First and Second National Banks

8.1.1  General Background and Powers

The First Bank of the United States, inspired by Alexander Hamilton, was chartered for a twenty-year term in 1791, during the Washington administration.13 Its term was not renewed in 1811.14 Shortly thereafter, the Second Bank of the United States was chartered in 1816 during the Madison administration, also for a twenty-year term.15 Its charter was also not renewed in 1836 when Jackson was President.16

The Second Bank was much larger than the First Bank, as it had $35 million in equity capital, whereas the First Bank had only $10 million.17 However, both the First Bank and Second Bank were very large, as compared to the existing state-chartered banking system: the First Bank’s $10 million in equity capital was three times the equity capital of all state banks in the United States combined,18 and the Second Bank’s $35 million in equity capital was ten times the equity capital of the largest state bank.19 At the time of the First Bank’s charter, the United States had $204 million nominal GDP; by the Second Bank’s charter, this figure grew to $811 million.20

Both the First Bank and the Second Bank played three important roles in the United States economy. First, both Banks bought large amounts of war debt. The First Bank bought state government issued debt from the Revolutionary War and the Second Bank bought debt from the War of 1812. In fact the Banks were initially capitalized by exchanging equity for war debt and specie (i.e., hard money like gold and silver).21 Purchases of state debt by the First Bank were intended to avoid defaults by the state governments.

Second, both Banks lent substantial sums to private entities, including but not limited to state banks, thereby increasing credit in the US economy.22 The Banks would do so by lending US bank certified notes to borrowers, which would then use the US bank notes as currency. Both banks were required by law to meet any redemptions of outstanding US bank notes in specie.23 As a result the First and Second Banks sought to maintain specie reserves one-third the size of their circulation of US bank notes.24 It is important to note that during this time, state banks would lend to private entities using state bank notes, which were also then used as currency.25 State banks were regulated by state governments and were also required to meet any withdrawals of state bank notes with specie.26 State banks had had no required minimum ratio of specie reserves to state bank notes.27

Third, the First and Second Banks each exerted indirect control over state banks’ ability to extend credit by issuing state bank notes, in effect engaging in monetary policy. The First and Second Banks sought to do so to ensure that these state banks were not issuing too many state bank notes without sufficient specie on hand to pay state bank noteholders. Congress considered this among the most important—and controversial—functions of the First and Second Banks.28

The First and Second Banks were able to exert control over state bank note issuance, since the First and Second Banks each held a large amount of state bank notes and could therefore present a state bank with its notes and request redemption from the state bank in specie.29 Redemption requests would further reduce a state bank’s specie reserves, thereby reducing the state bank’s ability to legally or credibly issue more notes.30 The First and Second Banks held such a large stock of state bank notes because they were the US Treasury’s depository, and taxpayers would often pay taxes in state bank notes.31 The First and Second Banks also typically lent to state banks with specie as collateral for the loan, so if they questioned the specie reserves of the state bank they could seize the state bank’s specie.32 Of course, this would further reduce a state bank’s specie reserves. For example, the First and Second Banks did this to address “wildcat” banks in the west and south from issuing too many notes without sufficient specie.33

The First and Second Banks were also able to effectively expand credit in the US economy. They could do so by treating state bank notes “with forbearance” (i.e., would not call for those notes’ redemption), even if the state banks specie reserves were low, while simultaneously increasing the availability of its own credit to businesses and state banks.34 The Second Bank did this during the crash of 1831–32 in order to mitigate the effects of that crash on the US economy. These actions, in large part, ultimately led to the failure to renew the charter of the Second Bank.35 Not only did such policies address credit creation, they also allowed the national banks to control the potential insolvency of state banks.

8.1.2  First Bank of the United States (1791–1811)

The legislation establishing the First Bank of the United States provided that for a twenty-year term, renewable at the discretion of Congress and the President, no other national bank could be congressionally authorized. Under its charter, the Bank was a private institution that was permitted to lend to private individuals and businesses. Private speculation on new government bonds and on the United States response to Revolutionary War debt consolidation was at least partially responsible for the impetus behind private backing of the First Bank.36

Despite being set up as private enterprise, the First Bank was an instrumentality of the government from its inception. The Bank was both the government’s creditor and debtor: its creditor because it held government debt, and its debtor because it held government deposits.37 At the bank’s inception, 60 percent of the First Bank’s assets were government securities, either state issued war debt or US government debt.38 The US government was also a part owner of the First Bank, as the government subscribed to 20 percent of the initial public offering (private investors owned the remaining 80 percent).39 The Bank was headquartered in Philadelphia but had branches in several states.

When state banks or the First Bank (and Second Bank) received specie deposits from individual investors, it would issue these depositors notes as a form of receipt, which was circulated as money. These banks would also make loans, for which they would issue bank notes, also redeemable in specie, to the borrower. The Bank of the United States was able to issue ordinary demand US bank notes for its loans, with denominations greater than $5; it was also able to issue US bank notes for various amounts and dates of payment, which could be transferred by the original owner’s endorsement.40 These notes were receivable at any First Bank or Second Bank branch; state bank notes were also receivable at First Bank or Second Bank branches.41

In its early years, the First Bank’s heavy load of government obligations, acquired from the states, limited its capacity to lend privately; however, after government loans were liquidated at the end of 1796, private lending was able to expand.42 Table 8.1, from Jefferson’s letters to Treasury Secretary Gallatin, shows the Bank’s balance sheet in 1801.

Table 8.1

First Bank holdings, 1801

Source: Holdsworth, supra note 1063, at 138.

The controversy that led to Congress’ failure to renew the First Bank’s charter generally stemmed from two sources. First, state banks were dissatisfied with the effective curtailment of their note issuance by the First Bank. Second, there was the fear that the Bank would become a “government subsidized monopoly designed to benefit only a small part of the population.”43 Populist sentiment evinced fear that centralization of any kind could impair national development and undermine individual rights.44 Further Thomas Jefferson and James Madison feared the Bank’s concentration of financial power would disproportionately benefit northern trade and commerce at the expense of farmers across the rest of the country, as its branches (and by extension, their reserves) were concentrated in the north. This imbalance would encourage the Bank to make more loans to northern banks and individuals.45

Although some would emphasize the illegitimacy of a government bank lending to the private sector, this was a minor consideration in the failure of the bank to survive. The issue was rather control of state bank notes and federal power. And there was no focus at the time on the power of the bank to lend to other banks, as a protean lender of last resort. But that baby was thrown out with the bathwater.

8.1.3  Second Bank of the United States (1816–1836)

The Second Bank of the United States was established just a few years after the first Bank’s charter lapsed. Its establishment was largely due to the stress to the American economy from the War of 1812. Embargoes paired with heavy wartime resource demands had resulted in a considerable government deficit.46

Private investors, rather than the government, had purchased government loans taken out in connection with the war; when the value of those government loans fell, these investors lobbied for a new national bank as a means of enhancing the value of their holdings.47 By August 1816, after the British burned the White House and the Capitol, these investors—including John Jacob Astor, Stephen Girard, and later Treasury Secretary Alexander James Dallas—felt they could wait no longer and formed a plan for recouping their investments.48 As with the First Bank, speculation and arbitrage opportunities resulting from these private investors’ holdings were a driving force behind these wealthy, powerful individuals’ backing for the establishment of the central bank.49

These investors’ plans laid the basis for the Dallas–Calhoun bill that would charter the Second Bank of the United States. The Bank would be chartered for twenty years, with capital of $35 million. As the First Bank before it, the government would own 20 percent of the Bank’s stock, and the public would own 80 percent. Bank equity capital was paid for with one-quarter specie, three-quarters in government bonds.50 Although Madison had vocally opposed the First Bank during its congressional approval hearings twenty years earlier, as President he expressed no similar concerns in the second Bank’s ratification process.

Just like the First Bank, it was provided by legislation that the Second Bank must be able to pay its noteholders in specie at all times, although there was no explicit requirement for minimum amounts of specie to notes issued. To allay Democratic-Republican fears that the large capitalization of the Bank would make it a “mammoth machine” working against the best interests of the nation’s economy, the institution’s equity capital could never be raised above $35 million.51

With regard to ensuring that state banks maintained sufficient specie, the Second Bank’s approach was not consistent among all state banks.52 This is because banks located in metropolitan centers, like New York and Philadelphia, generally were much more reliable in their efforts to maintain sufficient specie to state bank note issuance than state banks located in country districts in the far south and west.53 As a result the Second Bank needed to carefully monitor the specie and note issuance by rural state banks and could take a more hands-off approach to the banks located in metropolitan cities.54

The first and second presidents of the Second Bank, William Jones and Langdon Cheves,55 mismanaged the Second Bank by extending too much credit to state-chartered banks and individuals.56 By mid-1818 the Second Bank and its branches had issued such a large amount of US bank notes that its specie reserves were comparably low and there was a risk that the Second Bank would not have sufficient specie to meet redemptions by US bank noteholders.57

When Langdon Cheves became the second president of the bank at the beginning of 1819,58 he forbade the branches of the Second Bank to issue any more US bank notes.59 In order to increase its specie reserves, the Second Bank was required to collect payment of some of their loans. This shifted balance sheet pressure from the Second Bank to state banks in three important ways. First, for state bank notes held by the Second Bank as payment for taxes, the Second Bank simply redeemed such notes for state banks’ specie.60 Second, for Second Bank loans directly to state banks, the Second Bank asked for repayment in specie, further draining the specie reserves of state banks.61 Third, many of the Second Bank’s loans to other borrowers were repaid by those borrowers in state bank notes, which the Second Bank would then convert to specie by taking the notes to the state bank for redemption in the state bank’s specie.62

Of course, state banks reacted negatively to this balance sheet pressure shift. For example, state banks in Georgia and North Carolina loaned extensively to land buyers, farmers, and country merchants during the late 1810s and early 1820s. Although these banks had sufficient specie for otherwise ordinary commercial transactions, they “could not withstand the claims which might be made by the (Bank of the United States) bent on obtaining specie.”63

The resulting contraction of credit was widely thought to have contributed to, or at least increased the hardship produced by, the recessionary Panic of 1819. Although the effect on the US economy was largely negative, the Second Bank was successful in raising its ratio of specie reserves to US bank notes from a low of 12 percent in 1818 to a high of 61 percent in 1821.64

After the specie crisis at the Second Bank was resolved, its third president, Nicholas Biddle, once again expanded the institution’s role as a provider of credit and stability beginning in approximately 1822. Under Biddle’s direction, the Second Bank was effective in ensuring that state banks had sufficient specie to back note issuance.65 Jeffersonian Albert Gallatin wrote that the Second Bank had “effectually checked excessive issues” by the state banks, and “that very purpose” for which it had been established had been fulfilled.66 In 1833, he wrote to Bank of England director Horsley Palmer that “the Bank of the United States must not be considered as affording a complete remedy,” for the ills of overexpansion, “but as the best and most practicable which can be applied”; and its action “had been irreproachable” in maintaining a proper specie reserve position “as late as November 1830.”67

From 1831 to 1832, fluctuation in European exportation caused an unfavorable balance of trade with the United States, which caused a slowdown in the US economy. The Second Bank acted to mitigate the harm to the economy by expanding loans to state banks and other private entities.68 During this time the Second Bank allowed specie reserve to fall by 41 percent.69 The Second Bank did so “to relieve the community from the temporary pressure to which it was thus exposed.”70

During the 1831–32 credit crisis, the Second Bank redeemed notes for specie from banks in Boston, New York, Baltimore, and Philadelphia that had maintained large specie reserves.71 The specie that the Second Bank received from these efforts enabled the Second Bank to expand loan making to banks in the west and southwest, where loan issuances had expanded beyond state banks’ capacity to repay with specie.72

The success of the Bank’s stabilization efforts during this crisis increased the Bank’s popularity even among state bankers that had been previously opposed to the Bank’s influence.73 Of the 394 state banks that existed in 1832, none petitioned Congress to withdraw the Bank’s charter; 61 sent memorials in favor of renewal.74

Like its predecessor, the Second Bank of the United States was also a controversial entity. Allegations of corruption at the Second Bank’s local branches began as early as 1825.75 Branch officials in South Carolina, Louisiana, New Hampshire, Georgia, and Virginia were accused of “unjustifiable political activity,” incurring suspicion that the Bank would engage in political favoritism by lending at disproportionately favorable rates to preferred borrowers.76 After investigation by Jacksonian officials, these charges were largely found baseless; no charges were ever levied against the parent board.77

Andrew Jackson and other Democrat-Republicans, who complained that the Bank posed a threat to states’ rights, were the primary source of Bank criticism. When Jackson assumed the presidency in 1829, the Second Bank was thriving under Biddle’s leadership. The dollar was in good health; the Supreme Court reaffirmed the Second Bank’s constitutionality;78 and the Treasury continued to use it as an official depository.79 However, Jackson’s first message as President was that “both the constitutionality and the expediency of the law creating the bank were well questioned by a large portion of our fellow-citizens.”80

In 1832, congressional hearings were called in response to the Second Bank’s actions during the 1831–32 crisis. At these hearings Biddle’s interaction with the legislature—one wary of the Bank’s overreach—exacerbated tensions. Biddle, citing the Bank’s 1831–32 specie outflow and loan issuance as a means of ameliorating the economic downturn, asserted that the Bank’s decisions to provide credit to the market in times of crisis worked in the best interest of the entire market.81 Anti-Bank members of Congress viewed this statement as Second Bank management overstepping its mandate and threatening congressional authority.82 One member of Congress expressed his trepidation at the link between the Bank and Congressional authority: “This vagrant power to erect a bank … has at length been located by [Secretary of the Treasury Crawford] on that provision to lay and collect taxes.”83 John Quincy Adams similarly remarked, “power for good is power for evil, even in the hands of Omnipotence.” He and many others in Congress believed that “the soundest discretion may come to different results in different men.” Regardless of the Bank’s benevolent intent and, often, similarly benevolent results, Congress feared the Bank’s power and discretion in helping shape American markets.84

In 1832, Henry Clay, during his presidential campaign against Andrew Jackson (who was running for reelection), introduced a bill to renew the second Bank’s charter four years early.85 Introducing the bill during the campaign was intended to minimize the chance that Jackson would veto it, lest he provide his political opponents with grounds for criticism.86 However, Jackson not only vetoed the bill on July 10, 1832, but he used the veto message to send a strong populist message to his voters.87 The message focused on the “exclusive privileges” granted to the Bank and its stockholders and contrasted them with the experience of the ordinary American: “when the laws undertake to add to these natural and just advantages artificial distinctions, to grant titles, gratuities, and exclusive privileges, to make the rich richer and the potent more powerful, the humble members of society the farmers, mechanics, and laborers who have neither the time nor the means of securing like favors to themselves, have a right to complain of the injustice of their Government.”88 In December 1832, shortly after the veto, President Jackson, now reelected, ordered the withdrawal of federal deposits from the Bank, instead moving them to a newly established group of “pet” banks that would serve as depositaries for federal government assets. Under President Jackson and newly appointed Treasury Secretary Roger Taney, President Jackson’s close ally, all government revenues were placed not with the Second Bank but in certain state banks they would select. The remaining government assets within the Second Bank, in the tens of millions at the time, would be drawn upon for all government expenditures until that amount was exhausted.89

Less than a year after the Bank’s close, the United States experienced the Panic of 1837, in which money supply fell 34 percent between 1838 and 1842 and prices decreased 33 percent from 1839 to 1843.90 There was no Bank of the United States available to expand credit.

The Second Bank of the United States, much more than the First Bank, did, in effect, play the role of lender of last resort to the banking system, by forbearing specie redemptions in weaker banks, and did so successfully to maintain financial stability. This accounted for its popularity with the states. However, there was a continued fear of the misuse of federal power. Again, the baby of lender of last resort was thrown out with the bathwater of such federal power.

8.2  Creation of the Federal Reserve System in 1913 and Its Authority as Lender of Last Resort to Nonbanks

In the United States, a series of nineteenth-century banking panics led to the creation of the Federal Reserve System.91 According to Laeven and Valencia (2013) the United States experienced major banking crises in 1837, 1839, 1857, 1861, 1873, 1884, 1890, 1893, 1896, and 1907.92 In each case, liquidity crises suffered by New York banks significantly amplified the initial panic, ultimately leading to a nationwide run on banks.

During these crises the United States did not have a central bank to provide liquidity, so stabilizing the banking system required a private solution. The private solution routinely involved private bank clearinghouses that would act together upon the onset of a crisis and provide the necessary liquidity.93 In each crisis, clearing houses in large cities such as New York and Chicago primarily acted as private lenders of last resort by providing emergency reserve currency.94 The effectiveness of such actions was varied.95 J. P. Morgan (the man) also often played this role by pledging personal funds and organizing top bankers to support illiquid but solvent banks.96 However, after the numerous crises and the realization that J. P. Morgan would not always be around to save the financial system, public support intensified for a central bank to regulate the banking sector and act as an official lender of last resort.97 More important, while private institutions had become adept at responding to a crisis, the only way to prevent a panic in the first place was to establish a lender of last resort that is “sufficiently credible such that depositors always believe it can … purchase the assets of the banking system.”98

By 1913, leading bankers and government officials increasingly agreed that a single centralized lender of last resort was needed.99 Congress hence enacted the Federal Reserve Act in 1913, which provided the Federal Reserve with lender-of-last-resort powers.100 However, weakness of the Federal Reserve’s 1913 lender-of-last-resort authorities was exposed during the banking panics of the early 1930s. At that time the Federal Reserve was prohibited from lending to nonmember banks, and was only permitted to accept a few types of collateral—primarily short-term commercial and agricultural loans, in addition to Treasury securities.101 When these legal constraints were in place, 65 percent of commercial banks representing 25 percent of deposits were nonmember banks that had “no direct access to the lender of last resort.”102 History shows that deposits held at nonmember banks were clearly at greater risk than deposits at member banks. For example, between 1930 and 1932, one dollar of deposits held at a nonmember bank was five times more likely to be affected by a bank’s suspension of operations than one dollar of deposits held with a member bank.103 In 1932, following the chaos in the early years of the Great Depression, Congress adopted two major expansions of Federal Reserve’s lender-of-last-resort authorities: Sections 10(b) and 13(3) of the Federal Reserve Act.

First, in February, Congress enacted the Glass–Steagall Act of 1932, which amended the Federal Reserve Act to include Section 10(b).104 Section 10(b) authorized the Federal Reserve, under “exceptional and exigent circumstances,” to lend to member banks against a much broader set of collateral than was previously permitted.105 Although the provision was initially intended to be temporary, subsequent legislation extended its lifetime indefinitely and removed the requirement that such lending only take place in “exceptional and exigent circumstances.”106 The Monetary Control Act of 1980 required all depository institutions to hold reserves and opened discount window lending to any institution holdings reserves, thus extending this lending to nonmember banks.107

The Federal Reserve continues to act as a lender of last resort to banking institutions through the discount window under Section 10(b), which was redesignated 10B in 1991.108 Discount window loans from the Federal Reserve must be “secured to the satisfaction of [the] Federal Reserve bank.”109 Acceptable collateral that can include government and agency securities, ABS, corporate bonds, money market instruments, and residential and commercial real estate loans, among other eligible securities.110 Fed policy (as distinct from the statute) does not permit unsecured discount window lending, so institutions with no acceptable collateral cannot access it.111 However, subject to several limitations, including the consent of five members of the Board of Governors, the Federal Reserve can lend to groups of five or more member banks that do not have sufficient eligible collateral to borrow through 10B.112 In such cases, recipient banks must “deposit with a suitable trustee, representing the entire group, their individual notes made in favor of the group protected by such collateral security as may be agreed upon.”113 Lender-of-last-resort liquidity support obviously does not carry the same level of risk to taxpayers as straight (and obviously unsecured) capital injections. A recent paper by Martin Hellwig, for example, notes that central banks may have loaned to insolvent institutions during the crisis but that central bank support to banks of dubious solvency does not hurt taxpayers since the central bank is not in danger of losing any money (though inflation may occur and loss of reputation may be at stake).114 Even Lehman Brothers’, which owed the Federal Reserve $46 billion on the date of its bankruptcy, paid back its Fed loans only three days later.115 The lender of last resort does not generally loan to insolvent banks, banks that have lost money due to ineptitude, but there is nothing in Section 10B that prevents it from doing so. The power is designed to protect banks and the financial system as a whole from being victimized by destabilizing contagious panics.

Second, in July 1932, “tucked away in a road construction measure” called the Emergency Relief and Construction Act, Congress amended the Federal Reserve Act to include Section 13(3).116 Section 13(3) allowed the Federal Reserve, “in unusual and exigent circumstances [and after an] affirmative vote of not less than five members,” to lend to “any individual, partnership, or corporation”117 Prior to 2008, the Fed made few loans under Section 13(3), with most coming between 1932 and 1936 to 123 institutions for an aggregate amount of $1.5 million.118

As initially enacted, Section 13(3) lending was required to be “secured to the satisfaction of the Federal Reserve bank”119 by collateral “eligible for discount for member banks under” Section 10B.120 This collateral requirement effectively limited the Fed’s ability to lend to nonbank financial institutions, including investment banks, that primarily held investment securities that were not eligible as collateral.121

Less than two weeks before signing 13(3) into law, President Hoover had vetoed a similar provision that would have enabled the Reconstruction Finance Corporation to lend to individuals.122 He expressed concern that granting these authorities “would place the Government in private business in such fashion as to violate the very principle[s] … upon which we have builded our nation.”123 Although there is scant legislative history to support the hypothesis, it is plausible that the onerous collateral requirement was a legislative bargain that enabled the provision to escape veto.

The 1987 financial crisis, however, led to an amendment of Section 13 that increased the discretion of the Federal Reserve to lend to nonbanks by removing the heightened collateral requirement. In 1991 the FDIC Improvement Act amended Section 13 of the Federal Reserve Act by striking “of the kinds and maturities made eligible for discount for member banks under other provisions of this Act.”124 This opened the door for all notes, drafts, and bills of exchange to be eligible as collateral and left the adequacy of the collateral to the “satisfaction” of the Fed.125 Senator Christopher J. Dodd (of the Dodd–Frank Act) ironically authored the 1991 legislation that expanded the LOLR powers of the Federal Reserve, arguing that the expanded powers gave the Federal Reserve “greater flexibility to respond in instances in which the overall financial system threatens to collapse.”126

In short, before Dodd–Frank, the main predicates of emergency §13(3) lending were a five-of-seven vote by the Federal Reserve Board members coupled with the inability of the recipient institution “to secure adequate credit accommodations from other banking institutions.”127 Funds were required to be “secured to the satisfaction of the Federal Reserve,”128 leaving the appraisal of the adequacy of collateral posted by recipients to the Board’s discretion. Under these circumstances the Federal Reserve was authorized to act as the lender of last resort to individual nonbanks including “[i]ndividuals, [p]artnerships, and [c]orporations” in “unusual and exigent circumstances” by §13(3) of the Federal Reserve Act.129 Combined with the discount window, §13(3) enabled central bank liquidity to reach potentially the entire bank and nonbank financial system (to the extent that borrowers could post collateral that the Federal Reserve deemed to be adequate).

As already noted, during the financial crisis of 2007 to 2009 the Federal Reserve exercised its §13(3) liquidity power through the creation of a sweeping series of novel borrowing facilities, several of which were intended to benefit nonbanks. Section 13(3) also formed the statutory basis for the Federal Reserve assistance of selected individual nonbank financial institutions, including Bear Stearns and AIG.130

The Federal Reserve also acts as international lender of last resort through swap lines under authority codified in the 1980 amendments to the Federal Reserve Act, specifically Section 14(a) and 14(c).131 Through the swap lines, the Federal Reserve lends US dollars to foreign central banks, which may then be lent to foreign or US institutions. While the use of swap lines was useful during the financial crisis and the subsequent crisis in the eurozone, a potential critique of swap lines is that they could be used as a “backdoor” use of the Fed’s authority to lend to nonbank financial institutions, thus circumventing the limits on such lending established by Section 13(3). However, the Fed’s authority to grant swap lines rests on authority separate from 13(3) and is thus not restricted by 13(3). Fortunately, Dodd–Frank prudently did not limit the Federal Reserve’s authority to use swap lines. Restrictions would pose major concerns for foreign central banks having dollar liabilities of their own banks.