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10. Comparison of LLR Powers of Fed with Bank of England, European Central Bank, and Bank of Japan

Published onApr 08, 2020
10. Comparison of LLR Powers of Fed with Bank of England, European Central Bank, and Bank of Japan
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The Fed’s three major peers are the Bank of England, the European Central Bank, and the Bank of Japan. This chapter concludes that the Federal Reserve is currently the weakest of the four. The chapter begins with a description of the powers of the three peer central banks and then compares their powers with those of the Fed.1

10.1  Bank of England

The Bank of England (“BOE”) was originally formed as a private corporation in 1694 by Royal Charter, pursuant to the Bank of England Act 1694.2 As Mark Carney, the Bank of England Governor, recently noted, the Bank’s assumption of the lender-of-last-resort role was gradual, but by the end of the nineteenth century, the “promotion of financial stability through its role as the effective lender of last resort” was among the BOE’s informal responsibilities.3 Thus the BOE’s role as lender of last resort was established informally early in its history, although it was not effectively codified into law until 2009.

In 1946 the BOE was nationalized and its capital stock was transferred to HM Treasury (“the Treasury”).4 However, according to Governor Carney, “the BOE’s responsibilities remained broad and largely informal until 1997.”5 The BOE’s independent responsibility for monetary policy was then codified by the Bank of England Act in 1998, which established that the Treasury may not give direction on matters of monetary policy.6 According to Governor Carney, the BOE’s lender-of-last-resort authority is derivative from its monetary policy authorities. “Central banks have a primordial responsibility to act as guarantors of trust and confidence in money because of their status as monopoly issuers of currency. This naturally gives them control over the quantity of money and interest rates—monetary policy. It also means that a core part of financial stability policy—acting as lender of last resort to private financial institutions at times of financial stress—falls naturally to central banks.”7 This conception of a subsidiary role for lender of last resort is different than the experience in the United States, where the Federal Reserve was created in 1913 to deal with financial panics which the private sector proved unable to deal with—only later came its role in monetary policy.

The formulation of the BOE’s role further changed with the Banking Act of 2009, which established that “[a]n objective of the Bank shall be to contribute to protecting and enhancing the stability of the financial systems of the United Kingdom.”8 The BOE now identifies its mission as being “to promote the good of the people of the United Kingdom by maintaining monetary and financial stability.”9 Moreover the BOE expressly acknowledges that “financial stability requires an efficient flow of funds in the economy and confidence in financial institutions. This is pursued through … the Bank’s financial operations, including as lender of last resort.”10 Furthermore Deputy Governor of the Bank of England, Minouche Shafik, has recently pointed out that “[s]ince the onset of the financial crisis, to keep the financial system open for business, central banks have used their balance sheets as never before.”11

10.1.1  Sterling Monetary Framework

The BOE’s Sterling Monetary Framework (“SMF”) is the BOE’s set of publicly available guidelines governing its money market operations to implement monetary policy.12 The BOE publishes a summary of the programs in the “Red Book.”13 The events of the global financial crisis gave rise to the review and reform of the SMF. Although the SMF had historically focused on monetary policy operations, the 2008 consultative paper issued by the BOE “for the first time recognised that it should be an explicit objective of the SMF to provide liquidity insurance to the banking system to ‘reduce the cost of disruption to the liquidity and payment services supplied by banks to the UK economy.’”14 The Red Book was formally revised in its 2010 publication to incorporate the findings and recommendations of both internal BOE review and the House of Commons Treasury Committee.15 The most recent version of the Red Book was published in June 2015.16 Under the current SMF, the BOE provides details regarding its discount window facility (“DWF”). This is the type of lending that is identified with the lender-of-last-resort role, outside a liquidity crisis.17 The Red Book also provides for a “contingency liquidity facility” that the Bank can activate in times of extreme market-wide stress, called the Contingent Term Repo Facility (“CTRF”).18

10.1.2  Participation in the Sterling Monetary Framework and Acceptable Collateral

Participation in the SMF is generally voluntary, and banks and building societies are eligible to apply for access at any time by submitting an application form and supporting documents to the BOE.19 A building society is a financial institution that provides banking services and is owned by its members, with the primary purpose of providing loans that are secured by residential property.20 Although SMF participants are required to submit extensive data filings clarifying that they are in compliance with all other prudential regulatory requirements (e.g., capital), they are not required to meet any additional prudential requirements for SMF membership. However, the terms for participation in the SMF clarify that “the BOE may, in its absolute discretion, waive, add to, or vary any or all of the criteria” for eligibility to participate in the SMF.21

In November 2014 the BOE opened SMF access to broker-dealers and central counterparties (“CCPs”), so they can now apply to use the discount window; this is similar to the expansion of access to the Fed’s discount window that took place in 2008 with the creation of the Primary Dealer Facility.22 The BOE expanded this access without approval from the Treasury. It is therefore possible that they could further expand access to these facilities to other nonbanks without consent of Treasury. Banks, building societies, broker-dealers, and CCPs make up the current group of institutions the BOE has deemed eligible for that facility.23 Broker-dealers, banks, and building societies are also eligible for CTRF use (when activated), while CCPs are not eligible.24 In order to be eligible for SMF participation, broker-dealers must be supervised by the Prudential Regulatory Authority and CCPs operating in the United Kingdom must be authorized under the European Market Infrastructure Regulation and subject to regulations approved by the European Securities and Markets Authority.25

The change in institutions eligible for the SMF followed June 2014 remarks by Governor Carney, that “in the coming year, the BOE will widen access to our facilities to include the largest broker-dealers regulated in the United Kingdom and to those central counterparties authorized to operate in UK markets.26 The change in policy reflects an understanding that these other financial institutions “provide critical financial services to the UK economy which expose them to liquidity risk.”27 In particular, the Red Book acknowledges that broker-dealers are key intermediaries in the capital markets and CCPs play an important role in managing credit risk.28 There is not a publicly available list of banks, broker-dealers, or CCPs that have registered as SMF participants.

SMF participants may borrow against a wide range of collateral, classified by the BOE into levels A, B, and C. The BOE’s acceptance of an expanded list of collateral is consistent with Governor Carney’s October 2013 announcement that “[t]he range of assets we will accept in exchange will be wider, extending to raw loans and, in fact, any asset of which we are capable of assessing the risks.”29 Level A collateral consists of high-quality, liquid sovereign securities.30 Level B collateral is also high quality and liquid, and includes supranational, mortgage, sovereign, and corporate bonds.31 Level C collateral includes loan portfolios and less liquid securitizations.32 Loan prices depend on the level(s) of collateral provided, and haircuts similarly vary according to the risk characteristics associated with certain types and classes of securities.33 The Bank provides detailed guidance on acceptable collateral and applicable haircuts on its website, as well as a fee calculator for prospective DWF borrowers to use.34 Recent indications are that the Bank may also accept equities as collateral from banks.35

10.1.3  Discount Window Lending

The DWF is available on demand to address financial instability at both individual institutions and in the markets generally, with certain limitations.36 Prospective DWF borrowers are asked to deliver eligible collateral a day or more before drawing.37 They are then required to initiate the request by phone and submit a “DWF Transaction Notice.”38 The Transaction Notice sets forth the proposed terms of the transaction and certifies that no event of default or potential event of default exists or will result from the DWF drawing.39 If the borrower cannot make such a certification then ELA would apply, as discussed below.

The DWF typically provides funding by lending gilts in exchange for less liquid collateral. Borrowers can then use these gilts to obtain cash at their discretion. The DWF does not lend cash directly, in order to control the facility’s impact on money supply and consequently on interest rates.40 The BOE may lend sterling cash directly in the event of that there are issues with the market for gilts.41 DWF loans have 30-day maturities for banks, broker-dealers, and building societies, and 5-day maturities for CCPs. DWF borrowers may apply to roll over the drawings, when needed over a longer period.42

As mentioned above, loan prices depend on the quality of posted collateral banks and building societies are charged a flat interest rate for borrowing up to an amount equal to 5 percent of their liabilities (25 bps above market rates for level A collateral, 50 bps above market rates for level B collateral, and 75 bps above market rates for level C collateral). The interest rate charged then increases linearly as the size of borrowing goes up between 5 and 15 percent of their liabilities. The terms of any borrowing greater than that must be discussed with the Bank.43 The cost for a broker-dealer is negotiated at the time of drawing, and depends on the quality of collateral and total size of that participant’s borrowing.44 CCPs also negotiate their loan price, which depends on collateral quality, at the time of drawing.45

The cost to access the DWF is designed to reflect “a premium to the market in routine circumstances but should offer SMF participants affordable liquidity in less normal conditions.”46 This is consistent with the traditional idea that borrowing from a central bank should be at a penalty rate, although this was not technically part of Bagehot’s classic formulation of the powers of lender of last resort.47 As Governor Carney noted, “[b]ecause we are both the supervisor and the central bank, the strong presumption is now that, if a bank meets the supervisory threshold conditions to operate and has signed up to our framework, it will be able to use our facilities. Our Discount Window will be open every day for those firms requiring a bespoke facility with lagged disclosure … [and] [i]ts price will be lower.”48 The BOE manages the impact of the potential stigma of DWF borrowing by not disclosing the borrowing activity of individual institutions, instead publishing the borrowing activity only as averaged across borrowers over the period of a quarter.49 And that information is itself published with a lag of over five quarters after the drawing is initiated.50

10.1.4  Contingent Term Repo Facility Lending

The Contingent Term Repo Facility, originally announced in December 2011, is another SMF lending option.51 The purpose of the CTRF is to supply cash in periods of “actual or prospective market-wide stress of an exceptional nature.”52 Accordingly, it is active only when the BOE implements it to respond to such market conditions.53 CTRF lending is also designed to accept the “full range of eligible collateral”: each of levels A, B, and C.54 The Bank determines the operational details of the CTRF (e.g., term, size, and price) each time the facility is activated.55 Distributions via the CTRF occur via a “uniform price” auction procedure.56 No CTRF operations have been initiated since late 2012.57 The CTRF is available to all SMF participants, except for CCPs. This includes banks, building societies, and broker-dealers.

10.1.5  Emergency Liquidity Assistance

Pursuant to Section 58 through 66 of the Financial Services Act 2012, the Bank of England, the Treasury, and the Prudential Regulation Authority are required to establish a memorandum of understanding (MOU) on financial crisis management that would provide the financial system with Emergency Liquidity Assistance (ELA) that goes beyond the BOE’s SMF.58 The need for the MOU, and overall clarification of the policies of emergency liquidity assistance, arose due to confusion over how such determinations were to be made during the 2008 crisis, particularly as it related to Northern Rock.59 The MOU on financial crisis management between the Bank, the Treasury, and the Prudential Regulation Authority sets forth the framework by which the Treasury and the BOE coordinate to provide this aid. Neither the Financial Services Act nor the MOU limits the types of financial institutions that may obtain ELA. Thus nonbanks as well as banks could use ELA.

The BOE’s current ELA disclosure policies reflect the need to provide this assistance confidentially, where premature disclosure could exacerbate market uncertainty and compromise the aid’s effectiveness. Until recently the Bank Charter Act of 1844 required the BOE to publish a weekly “Bank Return,” which provided a summary of the Bank’s balance sheet.60 Publication of the Bank Return could also result in the inadvertent disclosure of the Bank’s liquidity operations.61 During the financial crisis, the need for covert ELA was prominently highlighted by the 2007 run on Northern Rock.62 In response to the crisis, Section 245 of the Banking Act of 2009 removed the legal requirement to publish the Bank Return.63 On June 30, 2014, the BOE announced that it would replace the Bank Return with a new Weekly Report, and the first Weekly Report was published on October 2 of that year.64 The Weekly Report publishes balance sheet information pertaining to the Bank’s monetary policy operations, but excludes line items that could result in the disclosure of covert ELA.65 Sample publications are not available because the BOE has not extended ELA to any borrowers since the new Weekly Reports were instituted. However, the Weekly Reports are only required to disclose aggregate lending on a quarterly basis, with a five-quarter lag.66 Specific borrowers are not required to be disclosed.

10.1.6  ELA Assistance to Solvent Banks and Nonbanks

According to the MOU, the BOE may provide ELA, comprised of “support operations outside the Bank’s published frameworks” to solvent but “at risk” firms.67 This would include SMF participants where a potential event of default exists, as described in the discount window lending section above. The BOE may initiate the proposal to offer ELA to solvent firms, but it must notify and obtain approval of the Treasury before executing the aid.68 There is no public guidance or rules establishing the terms of these loans, including whether ELA borrowing must be collateralized.69 There is also no published guidance as to when ELA initiated by the Bank will be indemnified by the Treasury (i.e., the Treasury will cover any losses the BOE might incur as a result of its lending). Given that the Bank must obtain Treasury permission to extend ELA, it would seem consistent with the breakdown of roles for the BOE to seek such an indemnity before providing the aid.70 The idea of a Treasury indemnity is premised on the idea that emergency lending is as much a fiscal policy decision, normally reserved to the government, as much as a lender-of-last-resort function of a central bank. Even without a formal indemnity, the government in effect absorbs losses experienced by the central bank, since the losses erode the profits of the bank that would otherwise be remitted to the Treasury to support the general revenue.71 There is no direct threat to the viability of a central bank from operating at a loss, or even without capital, as it can create money.72 But there is a threat to its reputation. An indemnity insures that the central bank’s capital will not be eroded by ELA losses, so puts the Treasury at risk for erosions of central bank capital as well as lost central bank profits.

10.1.7  Lending at Treasury Direction

The MOU also provides that the Chancellor of the Treasury may direct the BOE to provide ELA to firms that the BOE does not judge to be solvent and viable or on terms that diverge from those the BOE proposes.73 A more general directive to “conduct special support operations for the financial system as a whole” with means that are not set forth in the Red Book may be issued by the Chancellor as well.74 These directions may only be made after the BOE has notified the Treasury of a material risk to public funds, and either (1) there is a serious threat to financial stability or (2) the Treasury has already committed public funds to reduce or resolve such a threat, and it would be in the public interest to do so.75 In the event of such direction from the Chancellor, the BOE is considered to be acting as the Treasury’s agent.76 As a result the funds are placed into an special purpose vehicle (SPV) that is segregated from the BOE’s balance sheet.77 In addition the SPV and the BOE are indemnified by the Treasury to cover any risks arising from actions so directed.78 The execution of a Treasury direction requires Parliamentary oversight. Under Section 63 of the Financial Services Act of 2012 and Section 32 of the MOU, the Treasury direction and the Bank’s proposed response must be “laid immediately before Parliament.”79 However, disclosure to the Parliament may be postponed in situations where confidentiality is crucial to financial stability (at the Treasury’s determination).80 Once the Treasury, in consultation with the BOE, has decided confidentiality is no longer necessary, the ELA assistance must then be laid before Parliament.81

10.2  European Central Bank

The European Central Bank (ECB) was established in 1998 pursuant to the Treaty on European Union and the Statute of the European System of Central Banks and of the European Central Bank (“ESCB Statute”).82 This makes the ECB extremely independent because its existence is protected by the equivalent of what would be a Constitution in a single country. The ECB is responsible for developing and implementing monetary policy for the European Union, through the primary objective of maintaining the stability of prices.83 The ECB is also responsible for assuring the stability of the financial system.84 To conduct these policies, the ECB coordinates with national central banks (“NCBs”) in the 28 EU countries (together, the “European System of Central Banks” or “ESCB”), particularly the 19 NCBs in the countries that have adopted the euro as currency (the “eurosystem”).85 The ECB’s tasks and authorities relating to the performance of central bank functions for the eurosystem are prescribed in the Treaty on the Functioning of the European Union (TFEU), as well as the ESCB Statute.86 Because the ECB functions as a central bank for the 19 members of the eurozone and shares powers with the NCBs, its role as lender of last resort is distinctive.

10.2.1  Emergency Liquidity Assistance

The treaties and ESCB Statute do not directly address lender-of-last-resort authority, and indeed there has been a lack of clarity about this role of the ECB.87 However, in its 2000 annual report, the ECB set forth that “Emergency Liquidity Assistance” (ELA), which is described below and is analogous to the traditional lender-of-last-resort role to financial institutions, is the province of the NCBs. More specifically, the ECB determined that ELA, which is “the support given by central banks in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions” was “the responsibility and cost of the NCBs.”88 Under this interpretation, ELA is treated as a “national task,” as contemplated by Article 14.4 of the ESCB Statute, pursuant to which NCBs “may perform functions other than those specified in this Statute … on the responsibility and liability of national central banks.”89 Accordingly, the NCB is generally responsible for determining the material terms of ELA. For example, a decision to exclude a particular type of financial institution from ELA eligibility would be set at the national level. The ECB also does not establish restrictions on borrowers’ use of ELA, so long as they are commercial purposes. In 2013 the ECB issued a statement on “ELA Procedures,” in which it effectively confirmed that traditional LLR should be provided by NCBs.90 One important consequence of leaving the basic authority with NCBs is that the loans are on their books (albeit consolidated for reporting purposes with the ECB), and losses from such loans are at the risk of the NCBs.

ELA becomes necessary when a solvent financial institution (or a group of solvent financial institutions) faces a liquidity shortage but does not possess sufficient collateral or does not meet the counterparty eligibility criteria to borrow via the ECB’s monetary policy open market operations and standing facilities.91 ECB policy does not permit an insolvent institution to borrow from it or a NCB and this appears to be the case whether or not the member state of the NCB would indemnify the NCB from loss.

Although ELA is technically available to “financial institutions” only banks have ever received ELA and there are no formal guidelines specifying whether nonbanks can also receive ELA funding. Thus it is not clear whether the ECB would allow NCBs to use ELA to lend to nonbanks, particularly if they were not supervised by the ECB or NCBs; as of now, this issue has not arisen. Although the ECB provides updated details regarding eligible collateral for use of its monetary policy facilities on its website, it does not specify what collateral is sufficient for ELA.92 Since 2007 the ECB has used a single framework for all of its credit operations across the eurosystem.93 The uniform framework makes no distinction between marketable and nonmarketable assets with respect to their eligibility as collateral, except that nonmarketable collateral cannot be used for outright transactions (where the Bank buys or sells in the market, resulting in a complete transfer of ownership).94 According to the new ECB guideline that went into effect on May 1, 2015, marketable assets are debt instruments admitted to trading on a market (e.g., government bonds, corporate debt instruments, and asset-backed securities), which meet certain specified criteria, and nonmarketable assets are fixed-term deposits, credit claims and retail mortgage-backed debt instruments.95

Eligible counterparties for participation in the ECB’s open market operations and standing facilities must meet certain baseline criteria separate from the collateral requirements. Notably, they must be “financially sound” and meet certain minimum reserve requirements set by the ECB.96 They must also be subject to supervision applicable to credit institutions and investment firms regarding compliance with Basel III requirements, as introduced in the EU in the form of the so-called CRD-IV.97 Banks’ compliance with CRD-IV’s capital requirements also appears to serve as a proxy to satisfy the “solvency” requirement for ELA recipients.98 The reliability of these data assumes that Basel capital is “real” capital. This is put in doubt by the fact that CRD-IV permits certain deferred tax assets to be counted as capital: in 2015 up to 57 percent of Greek banks’ common equity tier 1 capital was attributable to such assets.99

When an institution cannot produce collateral accepted by the ECB, an NCB may decide to bear the risk of lending to the institution via ELA.100 Although collateral posted for ELA may be of a lower quality than that used in eurosystem monetary policy operations, the ECB has stated that “adequate collateral” is necessary to receive ELA from an NCB.101 Otherwise, acceptable collateral is set by the NCB, and the ECB will intervene only on an ex post basis, if it considers the collateral to be insufficient. Indeed the ECB states that “NCBs can in principle autonomously design their own collateral framework for ELA, including the applicable risk control measures.”102 The ECB has also clarified that “central bank liquidity support should not be seen as a primary means of managing financial crises, since it is limited to the temporary provision of liquidity in very exceptional circumstances.”103

The lending NCB discloses certain details of the ELA loan to the ECB such as the interest rate, counterparty, maturity, collateral, and amount of the loan, but the ECB does not make these terms public.104 The NCB must also report to the ECB “the prudential supervisor’s assessment, over the short and medium term, of the liquidity position and solvency of the institution receiving the ELA, including the criteria used to come to a positive conclusion with respect to solvency.”105 In the case of a significant banking group now directly supervised by the ECB, this information supplements the data relating to solvency that the borrower has otherwise provided to the ECB. Although institutions “have to be considered solvent to be eligible … the exact terms and conditions for ELA are shrouded in even more secrecy than those of the ECB’s regular operations. So much so that Richard Barwell, economist at Royal Bank of Scotland, compares the rules of ELA with the rules of ‘Fight Club.’”106 If the ELA is expected to exceed €500 million, the NCB must notify the ECB in advance.107 ELA at a penalty interest rate was provided by certain NCBs during the eurozone crisis.108 Cyprus, Ireland, and Greece are among the countries whose financial institutions received such aid.109

Certain experts believe that the ECB itself, not just the NCBs, should provide ELA.110 Charles Goodhart and Dick Schoenmaker, for instance, argue that the ECB should be responsible for lender-of-last-resort functions for the significant banks in the EU banking union.111 Rosa Lastra argues that there is a statutory basis for this authority. Article 18 of the ESCB specifically empowers the Bank “to conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.”112 The ECB could use this authority to lend to a financial institution experiencing a liquidity crisis, thereby acting as a traditional lender of last resort.

10.2.2  ECB and European Commission Authority to Restrict NCB LLR

The ECB has the authority to “restrict ELA operations if it considers that these operations interfere with the objectives and tasks of the eurosystem.”113 An example of such a restriction would be the imposition of a cap on the amount of ELA that a particular NCB can provide, such as the cap on ELA established for Greece in early 2015.114 Under Article 14.4 of the ESCB Statute, such a determination can only be made with a two-thirds vote of the ECB Governing Council.115 Moreover an NCB must provide the ECB with details regarding any ELA loan within two days after extension, but the ECB does not make those details public. An NCB must also provide advance notice to the ECB if the funds will exceed €500 million.116 If the volume of funds is expected to be greater than €2 billion, the ECB Governing Council “will consider whether there is a risk that the ELA involved may interfere with the objectives and tasks of the eurosystem.”117 This requirement flows from the oversight role of the ECB regarding ELA as it relates to “the implementation of … single monetary policy.”118 The recently instituted Single Supervisory Mechanism, under which the ECB, in cooperation with the NCBs, oversees the banking sector and the implementation of banking rules across the euro area, represents an additional mechanism through which the ECB can supervise the provision of ELA.119

The provision of ELA by NCBs is also indirectly constrained by the European Commission’s policies regarding state aid. Under these policies, any assistance from a member state that is “incompatible with the common market” is not permitted; the European Commission must approve of state aid to confirm that it would not fall into this anticompetitive category.120 Such approval was given, for instance, in the case of the Bank of England’s loan to Northern Rock in September 2007, as the loan “was secured by sufficient collateral and was interest-bearing.”121 State aid clearance usually requires prior notice to the European Commission, but temporary rescue aid may be extended in advance of formal notice to the European Commission in certain circumstances.122 The Bank of England was therefore able to supply emergency assistance to Northern Rock without obtaining the European Commission’s pre-approval.123

In August 2013 the European Commission issued guidance on the application of state aid rules to the provision of ELA to financial institutions. ELA provided by NCBs could be implicated by the state aid rules, as “[d]edicated support to a specific credit institution … may constitute aid unless … [certain] cumulative conditions are met.”124 These conditions include (1) that the institution be temporarily illiquid but solvent, (2) that the facility be fully secured by collateral with the appropriate haircuts, (3) that a “penal interest rate” be applied, and (4) that the central bank act on its own initiative, and not be backed by a counterguarantee of the state.125 It is unclear as to what impact these Commission rules on state aid actually have on the ECB or NCBs in supplying ELA.

10.2.3  Liquidity via ECB Monetary Policy Operations

Although the ECB delegates ELA to NCBs, the Bank does provide market-level liquidity in crises through its monetary operations. During the recent financial crises, “[t]he broad range of collateral and counterparties in normal operations limited the need to adjust the framework and facilitated the supply of central bank liquidity, effectively allowing the eurosystem to become the main intermediary in the interbank market at the height of the crisis.”126 It is therefore difficult to draw a clear line between lender-of-last-resort activity and the provision of liquidity via monetary operations in the eurosystem. At a recent Bank for International Settlements conference on lender of last resort, it was noted that “an elastic currency supply [may be] a more useful concept than LOLR in the eurosystem context as measures there reflected responses to fluctuations in liquidity demand.”127

Importantly, Article 123 of the Treaty on the Functioning of the European Union (TFEU) prevents the ECB from purchasing sovereign debt instruments “directly from” EU governments or other public authorities.128 However, this provision can be circumvented by the authority the ECB does have to purchase sovereign bonds in secondary markets.129 Under Article 18 of the ESCB Statute, “in order to achieve the objectives of the ESCB and to carry out its tasks, the ECB … may … operate in the financial markets by buying and selling outright … and by lending or borrowing claims and marketable instruments … conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.”130 Section 18.2 provides that “the ECB shall establish general principles for open market and credit operations … including for the announcement of conditions under which they stand ready to enter into such transactions.”131

Thus Article 18 of the ESCB Statute empowers the ECB to conduct open market and credit operations, which can be used to supply liquidity to the market generally during a financial crisis.132 The ECB has implemented a number of unconventional monetary policies using its Article 18 authorities to respond to the 2008 global financial crisis and 2010 to 2012 euro crisis. These policies provided financial institutions with an important source of liquidity during these crises.

10.2.4  Long-Term Refinancing Operations

One major operation pursuant to its Article 18 authorities is the ECB’s long-term refinancing operations (LTROs), which it made use of in the 2008 and 2010–2012 financial crises.133 Through the LTRO program the ECB provides cash loans in euros to credit institutions at low interest rates (1 percent) in exchange for EU member state sovereign debt collateral. LTROs are considered to be open market operations, aimed at supplying liquidity to the financial sector.134 Although banks obtain loans through LTROs, the program is conducted as an unconventional monetary policy instead of the traditional lender-of-last-resort function; yet the purpose of the program is to provide liquidity assistance to the financial sector rather than to control the money supply. The size of the LTRO program peaked in December 2011 through February 2012, when the ECB used LTROs to inject approximately €1 trillion in cash into the European banking system.135 These funds were distributed via three-year LTROs to 523 banks in December and 800 banks in February.136

10.2.5  Purchasing Programs

In 2009, under its Article 18 authorities, the ECB undertook a €60 billion covered bond purchase program to restore the market in those instruments. This also provided banks with liquidity, as covered bonds are important sources of funding for financial institutions across Europe.137 In 2010, the ECB instituted the Securities Market Programme (SMP), whereby the ECB and NCBs purchased government bonds in the secondary markets.138 This policy falls within the letter of Article 123 of the TFEU, discussed above, since the transactions occurred in the secondary marketplace rather than via direct issuance.139 But the purchase of such bonds from the financial institutions has the effect of providing them with liquidity and was indeed undertaken for this purpose rather than as a means of controlling the money supply. In 2012, the Bank announced the implementation of a new program, Outright Monetary Transactions (OMT), to replace the SMP.140 Under OMT, the ECB would “address severe distortions in government bond markets” based on investors’ “unfounded fears” by purchasing government bonds in the secondary markets.141 The program resonates with Mario Draghi’s declaration shortly before OMT was announced that “[w]ithin our mandate, the ECB is ready to do whatever it takes to preserve the euro.”142 The OMT has not yet been implemented, but market conditions in the EU improved after its announcement.143 This program would seem to have more to do with supporting government bond markets than providing liquidity to financial institutions, but the willingness of the ECB to purchase these instruments from credit institutions, particularly at par, does provide them with liquidity they could not obtain in the private markets.

10.3  Bank of Japan

The Bank of Japan (BOJ) was originally founded in 1882 under the Bank of Japan Act.144 Its role as lender of last resort was highlighted during the depression in the 1920s, when the Bank extended special loans to banks in order to stem contagion throughout the financial system.145 The Bank was later reorganized under the Bank of Japan Act of 1942 (the “old Act”) and its lender-of-last-resort authority set forth in Article 25 thereof.146 The Bank exercised this authority liberally during a period of extreme financial turmoil in Japan during the 1990s.147 Following this period of instability, the Bank of Japan Act (“BOJ Act”) was enacted in 1997, creating the present day Bank of Japan.148 According to the BOJ, “independence” and “transparency” are the two primary principles underlying the Act.149 The 1997 amendment also organized the lender-of-last-resort procedures into three provisions: Article 33 (collateralized loans), Article 38 (special loans), and Article 37 (temporary uncollateralized loans).150 Although each type of loan is designed to address a different lending scenario, there are no express restrictions on borrowers’ use of funds under any of these provisions.

10.3.1  Article 33

The primary provision governing the BOJ’s lender-of-last-resort authority is Article 33 of the BOJ Act. Article 33 contemplates the flexible provision of collateralized loans by the BOJ, at the Bank’s sole discretion.151 Under Article 33, the BOJ may “make loans against collateral in the form of negotiable instruments, national government securities and other securities, or electronically recorded claims.”152 The BOJ provides further detail on eligible collateral and applicable haircuts on its website.153 The text of Article 33 does not limit this type of borrowing to banks, so a nonbank financial institution that is a BOJ account holder (e.g., a securities company or money market dealer that holds a current account at the Bank) could be eligible for an Article 33 loan, if they provide adequate collateral.154 Moreover there are no legal constraints regarding which types of institutions are eligible to hold BOJ accounts, although the Bank restricts certain cooperative institutions (e.g., credit unions) from holding accounts in order to efficiently allocate its resources.

The Bank extends Article 33 loans to institutions it deems solvent, based on the Bank’s on-site and off-site monitoring practices (discussed below). The loans do not require an indemnity from the Ministry of Finance, nor are indemnities sought. Two types of Article 33 loans exist: (1) loans for money market operations, to which a low policy interest rate applies, and (2) loans at the request of financial institutions under the Complementary Lending Facility, which are charged a slightly higher interest rate.155 The BOJ discloses only the aggregate value of loans extended under Article 33, not individual institutions’ borrowing activity.156

10.3.2  Article 38

The BOJ is authorized to extend special loans under Article 38 of the Act, which BOJ account holders and non-BOJ account holders may receive in certain circumstances.157 These Article 38 loans or toku-yu are intended to be undertaken only when “necessary for the maintenance of stability of the financial system.”158 The BOJ has made it clear that Article 38 loans may be uncollateralized, although this is not expressly stated in the legislation.159 In addition the text of the Act does not prohibit nonbanks or non-BOJ account holders from receiving such aid.160 Under Article 25 of the old BOJ Act, the BOJ initiated this lending process but had to obtain the prior approval of the Minister of Finance before extending such loans.161 The current Article 38 lending process must now begin with a request from the Prime Minster and the Minister of Finance for the BOJ to “conduct the business necessary to maintain stability of the financial system.”162 Thus, as a formal matter, BOJ cannot initiate such loans but it can still ask that the Minister of Finance request it to do so. The Policy Board of the BOJ then assesses in its sole discretion if special operations are necessary, including whether the extension of Article 38 loans is appropriate according to four principles.163 So, ultimately, loans requested by the Ministry of Finance can be rejected by the BOJ, unlike in the United Kingdom where loans requested by the Treasury must be made by the BOE if there is an indemnification.

The first, and most important, principle is that “there must be a strong likelihood that systemic risk will materialize.”164 The goal of a special loan to an individual firm must be to prevent systemic risk, not to rescue or protect that firm.165 Presumably this would be the case where the failure of the firm would have a significant impact on the rest of the financial system. The “Financial Crisis Response Council,” which includes the governor of the BOJ along with certain government officials (including the Prime Minister, Chief Cabinet Secretary, and Minister of Finance) typically makes the determination as to whether such risk exists. The second principle is that the Article 38 loans must be necessary for the borrower to obtain the funds—Article 38 loans should be available only when there are no other options.166 Third, the recipients must be penalized and held responsible to avoid moral hazard.167 This is different from a penalty rate. Such penalties might include replacing management and removing existing shareholders. These types of consequences are unique to lending by the BOJ as compared with its peers. Fourth, the BOJ’s financial soundness must not be jeopardized by the loan, so as to preserve public confidence.168 Considerations relating to the fourth principle include (1) that liquidity, not risk capital be provided, (2) that there be reason to believe that special loans are collectable, and (3) that provisions be set aside for each individual case, to prepare for potential losses.169

If the Policy Board of the BOJ finds that special loans are necessary, it determines details of the loans (e.g., costs or procedures for their extension) on a case-by-case basis, but a penalty interest rate is applied to uncollateralized loans.170 The Bank sets the terms at its own discretion and does not need or require an indemnity from the Ministry of Finance or government approval with respect to the loan terms.171 Interestingly, the extension of special loans and details regarding their terms are disclosed by press release shortly after these decisions are made.172 This is quite different than the case for other types of lending by BOJ or by the other peer central banks where the stigma following disclosure is thought to discourage borrowers from coming forward in the first place.

Importantly, the BOJ may also extend special loans under Article 38 to insolvent institutions “in exceptional cases, as measures to prevent a financial crisis from materializing.”173 These loans take the form of bridge loans to facilitate the resolution of failed institutions in situations where the Bank can rely on the government or Deposit Insurance Corporation of Japan (DICJ) to ensure funds will be available for the BOJ to collect on its loans.174 “For example, [they may be extended] when the government decides to fully guarantee all liabilities of failed institutions.”175 The Bank has only decided to provide special loans to insolvent institutions twice, but the loans were never actually extended because the DICJ’s resolution process rendered them unnecessary.176

10.3.3  Article 37

The Bank of Japan may also offer uncollateralized loans to financial institutions including non-BOJ account holders under Article 37 of the BOJ Act, in order to address temporary liquidity shortages.177 These loans are intended for “unexpected” shortages “due to accidental causes” (e.g., technological failures), where the funds are “necessary to secure smooth settlement of funds.”178 Uncollateralized Article 37 loans are provided for a maximum period of one month.179 The Bank may provide Article 37 loans at its own discretion and may determine their terms on a case-by-case basis, but must report any lending thereunder to the Prime Minister and Minister of Finance “without delay.”180 However, an indemnity from the Ministry of Finance is not required. The BOJ has not yet extended any loans pursuant to Article 37.

10.3.4  Article 44

The Bank of Japan conducts on-site examinations and off-site monitoring “to grasp the business and financial conditions of individual financial institutions” in connection with the exercise of its lender-of-last- resort authorities.181 On-site examinations of financial institutions that receive loans under Article 37 or Article 38 are contemplated under Article 44 of the BOJ Act.182 These examinations include visits to the institutions and an assessment of their business operations and property.183 Off-site monitoring includes “the analysis of financial data collected from banks and information obtained from bank management through interviews.”184 These procedures “ensure that the Bank prepares or adequately conducts … (1) temporary loans to financial institutions (Article 37 of the Act) [and] (2) business contributing to maintaining the stability of the financial system (Article 38 of the Act).”185

10.4  Comparison of LLR Powers of the Four Central Banks

The matrix in table 10.1 summarizes the lender-of-last-resort comparison presented above. The bottom line of this comparison is that the overall changes that Dodd–Frank made to the Fed’s lender-of-last-resort power has left the Fed with relatively weak authority as compared to its three foreign peers: BOE, ECB, and BOJ. This is not just a matter of concern to the United States but also to the world, given the economic importance of the United States and the fact that the dollar is the reserve currency. What are the key features of the comparison?

Table 10.1





















10.4.1  Independence

First, consider the overall independence of the four central banks (here unless specifically noted, ECB includes the NCBs). In a very real sense the most independent is the European Central Bank, which was created by Treaty among EU countries, almost the equivalent of a Constitution in a single member state. The other three banks were created by statute and can be limited or abolished by Congress in the case of the Fed or Parliament in the case of the BOE and BOJ. But it is important to recognize the different threat to the Fed from the Congress as opposed to the threat from the Parliaments of England and Japan. In parliamentary democracies, the parliaments are controlled by the government, indeed they form the government—this means they are more protected from their legislatures than the Fed, where the Congress is not part of the administration and indeed may be controlled by the opposite party from the President. Central bank independence has traditionally been thought of as independence from the government—is the Fed independent of the Secretary of the Treasury? But equally, and perhaps more important today, is the independence of the Fed from the Congress. It was the Congress that limited the Fed in Dodd–Frank and is increasingly attacking the Fed today for bailing out Wall Street. From the perspective of independence from a legislature, I would rank the Fed last.

10.4.2  Ability to Lend to Nonbanks and Supervisory Authority

Second, all four central banks have the power to be a lender of last resort to nonbanks, but none of the four central banks supervise all nonbanks to which they can lend. Thus they are faced with making lending decisions based, at best, on information from other regulators, such as the SEC or state insurance regulators in the United States. However, the BOJ does have the express statutory right to examine any institution to which it makes a loan, an idea that should be more widely adopted. Despite the fact that the Fed, BOE, and ECB lack such express authority, it is possible that they could require such supervision as a condition of granting a loan. This would be a prudent approach.

10.4.3  Regime Structure

While all four central banks have the power to be a lender of last resort to nonbanks, the Fed is the only central bank which has a different regime for banks and nonbanks: the discount window for banks versus Section 13(3) for nonbanks. These two regimes were made much more dissimilar by Dodd–Frank’s limitations on lending to nonbanks. With respect to banks, the Fed can lend, under Section 10B of the Federal Reserve Act, to a single bank, with whatever collateral it determines is sufficient, without the approval of the Secretary of the Treasury, and with no requirement that the bank be solvent. While the Dodd–Frank Act did not change Section 10B of the Federal Reserve Act, which is the main authority used to lend to banks, nonbanks are an increasingly important component of the financial sector, accounting for $25.1 trillion of the $37.9 trillion of credit market assets.186 With respect to nonbanks, under the terms of Dodd–Frank’s amendments to Section 13(3) of the Federal Reserve Act, the Fed must loan to nonbanks as part of a broad program, with adequate collateral as effectively approved by the Secretary of the Treasury, only with the approval of the Secretary of the Treasury, and with a requirement that the nonbank be solvent. In contrast, the other central banks have different regimes for normal liquidity and emergency liquidity, while the Fed does not differentiate between normal and emergency liquidity for banks, lending through the discount window in each case. For non-banks, though, the Federal Reserve only supplies liquidity during emergencies through 13(3).

10.4.4  Collateral

All four central banks accept a wide range of collateral for loans to banks and nonbanks, but only the US Treasury controls collateral policy for nonbanks—the three other central banks determine collateral policies on their own. While Dodd–Frank as a technical matter only requires the Fed to consult with the Secretary of the Treasury as to the adequacy of collateral, the power of the Secretary over whether to lend at all to a nonbank effectively gives the Secretary control of collateral policy as well—unlike the case with the BOJ and BOE where the right of the Treasury to approve loans explicitly does not extend to collateral policy.

Japan stands alone in permitting some emergency loans, those under Articles 37 and 38, to be uncollateralized. Recall in the crisis, that the Fed made uncollateralized loans to commercial paper issuers, but that authority appears to be taken away by Dodd–Frank. Whether or not collateral standards are published differs among different facilities and among different countries.

10.4.5  Requirement of Solvency

Fifth, the ECB requires borrowers from all of its facilities, including ELA facilities of NCBs, to be solvent. While the ECB may police NCBs’ compliance with this requirement, the “constitutional” independence of the ECB itself ensures that neither its control of the NCBs nor its own lending policies can be effectively policed. The political environment for exercise of lender-of-last-resort powers in the eurozone is also less hostile than in the United States. In this light, the solvency requirement could easily be diluted.

While in the United Kingdom, discount window borrowers must be solvent, and ELA initiated by the BOE also requires a solvency determination, the UK Treasury can order BOE to lend to an institution the BOE does not judge to be solvent, assuming that the Treasury supplies an indemnity. And the BOJ explicitly permits, under Article 38, some borrowers to be insolvent where its loans are a bridge to more permanent government funding. This is similar to what happened in the United States in the case of AIG, where a large part of the Fed’s initial exposure was later refinanced by the Treasury as part of TARP.

In the United States, while the Fed may have a general expectation that borrowers will be solvent (but again see AIG), such a requirement was not imposed by statute for banks or nonbanks before the crisis. Post–Dodd–Frank there is a requirement that nonbank recipient of loans must be solvent. The text of Dodd–Frank deems any borrower in bankruptcy, any federal or state insolvency proceeding, or resolution under Dodd–Frank’s Orderly Liquidation Authority, to be insolvent but does not exclude any other entities from the definition of insolvency.187 Accordingly, borrowers that are not subject to these formal proceedings could also be insolvent. It is hard to see why there should be a double-standard on solvency as between banks and nonbanks—lending to both can result in public losses and induce moral hazard. Solvency determinations are inherently difficult, particularly during a crisis and panic where asset values may represent fire-sale prices that could bounce back through the very provision of liquidity. This reality likely explains the flexibility built into the solvency policies in the United Kingdom and Japan. In contrast, the new nonbank express solvency requirement in the United States discourages the Fed from lending to nonbanks, given the prospect of congressional inquiries, particularly if a borrower later becomes insolvent.

Things could get worse for the Fed under the Federal Reserve Oversight Modernization and Reform (FORM) Act, which was passed by the House of Representatives in November 2015.188 The FORM Act would limit the Federal Reserve’s lending ability in a crisis situation.189 Per the bill’s provisions, the Federal Reserve could lend to non-banks only after 9 of 12 presidents of the Federal Reserve banks vote in favor of the action and after all Federal banking regulators with jurisdiction over the borrower, which would include agencies like the Consumer Financial Protection Bureau or even the SEC, certify that the borrower is solvent.190 Finally, the bill disallows lending to entities that are not “financial institutions.”191 While the bill is unlikely to pass in the Senate, the very introduction of more stringent solvency restrictions could well make the Fed gun shy to lend under its existing framework. Fed Chair Janet Yellen has spoken out strongly against the FORM Act, noting that the “FORM Act would essentially repeal the Federal Reserve’s remaining ability to act in a crisis.”192 Former Fed Chair Ben Bernanke has also warned of the dangers of limiting the Fed’s emergency lending powers. In his recent book, Bernanke notes that “still further restrictions on the Fed’s ability to create broad-based lending programs and to serve as a lender of last resort, could prove extremely costly in a future crisis.”193 As previously noted, this may be why he appears to accept the limitations of Dodd–Frank.

10.4.6  Treasury Approval or Direction

The relationship between the central bank and the Treasury also differs among the four countries. There are two key dimensions of this relationship. The first question is whether central bank loans can be initiated by the Treasury. This possibility exists in two countries, in the United Kingdom for BOE use of ELA, and in Japan for Article 38 emergency loans. Such a power is not applicable to the European Union, since there is no EU Treasury. No such power exists in the United States. Actually giving the Treasury the power to order such loans could strengthen the lender-of-last-resort powers where the central bank is reluctant to act. In the 2008 crisis, Secretary Paulson did not think he could obtain general funding authority from Congress,194 which likely contributed to his urging Chairman Bernanke to lend. Treasury orders to lend should probably be accompanied by indemnity as provided in the United Kingdom but not in Japan.

The second question is whether the Treasury must approve the lending of the central bank. Again, this is a moot point in the eurozone. In Japan, the BOJ can make Article 33 and Article 37 loans without Treasury approval, but the Treasury must itself initiate Article 38 loans. In the United Kingdom, the BOE can lend to banks and nonbanks through the discount window or CTRF without Treasury approval, but all emergency loans must be approved or directed by the Treasury. In the United States, only loans to nonbanks must be approved by the Treasury, and no indemnity goes with the approval. The requirement of Treasury approval in the US democracy, where such approval could be widely attacked by the Congress, and even in principle nullified, would seem much more important than in the context of the UK parliamentary democracy where the government generally controls both the Treasury and the Parliament. The requirement of US Treasury approval carries with it a significant enough degree of uncertainty to risk spooking the markets and accelerating panics. Some say any responsible Secretary of Treasury will have to approve Fed lending in a crisis due to the dire consequences of the failure to lend. But any Secretary of Treasury that approves such lending may be signing a future political death warrant, much like the many Democrats who voted for TARP. The irony is that if the lending is successful it is always easy to come back later and say it was unnecessary and bad to bail out Wall Street. One does not have the counterfactual of economic collapse to lay at the doorstep of critics.

The provision of liquidity to financial firms in difficulty always introduces a level of moral hazard, but requiring Treasury approval of loans does not eliminate the moral hazard—it merely shifts the source to the Treasury from the Fed. In addition, moral hazard concerns are limited in the case of lender-of-last-resort loans to solvent institutions that are victims of financial panic. These borrowers require assistance not because they took on too much risk but, rather, because of indiscriminate withdrawals by short-term creditors.

10.4.7  Need for a “Broad Program”

Only the United States prevents loans to single nonbanks, insisting instead on a broad program approved by the Secretary of the Treasury. This means that programs cannot be tailored to individual situations, as in the cases of Bear and AIG. Further, since runs often start somewhere, it makes it hard to stop the first run, and thus avoid the initial outbreak of contagion. Japan says emergency lending must be to prevent systemic risk, not to rescue a firm. But the US policy prevents loaning to a single nonbank for any reason, including that it may be the first nonbank subject to a run or that the loan needs to be customized, as was the case with AIG.

10.4.8  Disclosure Requirements

In Japan, Article 33 loans are disclosed only in the aggregate, and Article 38 special loans are disclosed by press release. The United Kingdom publishes only aggregate DWF and ELA information (with a five-quarter lag). And while ELA loans must, in principle, be immediately reported to the Parliament, this need not happen if confidentiality is crucial. In the ECB, disclosure policy on ELA loans is left to NCBs; I have not investigated the practices of different countries.

The United States has the most demanding disclosure policies, requiring discount window loans, including the borrower, to be disclosed publicly after two years and Section 13(3) loans to be disclosed publicly, including the borrower, after one year.195 Dodd–Frank also requires 13(3) loans to be reported to Congress with seven days.196 Such public disclosure raises the prospect of stigmatizing the borrower with the undesirable effect that needy borrowers will risk riding out withdrawals rather than borrowing from the Fed. This may lead to their collapse and to the broader collapse of the financial system.

10.4.9  Using Discount Window Proceeds to Lend to Affiliates

Finally, the United States is the only country that prohibits banks from using discount window loans to support their affiliates (e.g., broker-dealers). This requirement forces such affiliates to seek Fed funding independently as nonbanks, with the added conditions of nonbank funding. Even the UK “Vickers report” does not prohibit a bank from funneling central bank liquidity to a nonbank affiliate.197

In summary, the Fed is by far the weakest lender of last resort relative to its foreign counterparts and the Fed’s lender-of-last-resort powers are under political attack in the United States from both sides of the political spectrum. Even President Jeff Lacker of the Richmond Federal Reserve considers LLR as being part of the government safety net that is contributing to moral hazard, and argues for a weakening of such powers.198 While all four central banks reviewed above impose strict institutional constraints on lender-of-last-resort authority, the political unpopularity of this traditional function is heaviest in the United States. Just look at the ECB, which is not supposed to loan to insolvent banks, in principle, yet has lent amply to Greek banks. This is not only due to the ECB’s structural “constitutional” independence but also due to the fact that the general concept of lender-of-last-resort authority does not face the level of hostility in Europe that it does in the United States.

Apart from the political environment, institutionally the United States grants by far the weakest lender-of-last-resort powers to its central bank, particularly with respect to nonbanks: (1) its independence is more fragile; (2) it is the only country with special limitations on lending to nonbanks as compared with banks; (3) it is the only country, outside the eurozone, that makes no provision for loans to institutions the central bank does not judge as solvent (and as noted the eurozone requirement could be toothless); (4) while the BOE and BOJ require Treasury approval or direction for emergency lending, such requirements are likely to be much less politicized than the US Treasury approval of loans to nonbanks; (5) it is the only country that places restrictions on banks using discount window loans to support affiliates; (6) it is the only country requiring that there be a broad program for borrowing by nonbanks; and (7) it is the most aggressive country in requiring disclosure, thereby possibly inhibiting borrowers from borrowing due to the associated stigma. All but the first point results from changes by Dodd–Frank.

This US weakness is not likely to be rectified in the near future given the politics surrounding bailouts. Indeed, as the FORM Act demonstrates, the situation could get worse not better.

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