The Dodd–Frank Act placed important restrictions on the Fed’s power as lender of last resort to nonbanks under §13(3) as part of the post-crisis reaction that its lending constituted an undesirable bailout of “Wall Street.” Interestingly, this anti-bailout sentiment only manifested itself on restrictions on lending to nonbanks, rather than banks themselves. These restrictions, detailed below, have substantially curtailed the Fed’s ability to be an effective lender of last resort in a future crisis, and have made our financial system much less stable.
The following restrictions were placed on the Fed: (1) no loans can be made to single institutions—they must be part of a broad program approved by the Secretary of the Treasury; (2) all nonbank loans must be approved by the Secretary of the Treasury; (3) loans can only be made to solvent institutions; (4) discount window loans to banks cannot be used to fund their nonbank affiliates, like broker-dealers—instead loans to those affiliates must be authorized under §13(3); (5) new collateral requirements are imposed; and (6) all loans must be publicly disclosed within one year, and disclosed to congressional leaders in seven days. As noted in chapter 7, the Federal Home Loan Bank system played an important role as lender of last resort during the 2008 financial crisis. This authority was not curtailed by Dodd–Frank.
In another respect, Dodd–Frank’s Title VIII potentially broadens the Federal Reserve’s lender-of-last-resort capabilities with respect to financial market utilities designated as “systemically important,” which clearly covers clearinghouses which have already been designated.1 The designation process is conducted by FSOC, which has designated eight such firms as of the end of 2015.2 It could also include broker-dealers engaged in certain activities.3 Emergency lending under Title VIII would be conducted through discount window loans and not be subjected to the same restrictions that Dodd–Frank placed on §13(3) lending. However, not only is it unlikely that broker-dealers will be designated as financial market utilities, the designation requires the affirmative vote of the chair of FSOC (i.e., the Treasury Secretary), making this arguably just as onerous as emergency lending under §13(3).
The Dodd-Frank restrictions on 13(3) lending are particularly dangerous given the additional liquidity requirements imposed on financial institutions. However, Dodd-Frank’s new liquidity rules have shrunk private lending by requiring institutions to maintain their own liquidity, leading to hoarding. Thus, the ability of the Fed to encourage solvent and liquid institutions to lend in a crisis is constrained by their own liquidity regulations. Ironically, the liquidity requirements thus increase the need for Fed lending in a crisis rather than reduce it.
Section 1101 of Dodd–Frank requires §13(3) programs to have broad-based eligibility,4 thus prohibiting assistance to individual nonbank financial institutions undergoing runs or in danger of failing. Depending on the interpretation of “broad-based,” this requirement could compromise the ability of the Federal Reserve to prevent an incipient run emanating from a single institution—the run starts somewhere. While a financial crisis involves the run on a number of financial institutions, there will likely be a single institution that experiences the run first. Since that initial run could spark contagion, resulting in the failure of many institutions, it is necessary for the Federal Reserve to solve the problem at the outset. Waiting for multiple institutions to require liquidity support could result in the Fed lending into a run. Preventing the run in the first place would avoid that problem.5 As Secretary Geithner observed in his book Stress Test, when the Fed loans into a run, it is very difficult to make solvency determinations, since asset values are uncertain due to fire sales—one does not know whether the fall in prices can be corrected by the provision of liquidity, whether values would not have fallen but for the fire sales, or whether the losses are more fundamental. Allowing the possibility of lending to a single institution may then make it unnecessary to actually lend to a single institution, as the prospect of Fed lending will prevent any runs.
The Federal Reserve’s one-off loan to an insolvent AIG no doubt figured prominently in the background of this provision—this issue is raised in the House Financial Service Committee Report on Dodd–Frank.6 But this concern was separately met by Dodd–Frank’s insistence that loans only be made to solvent nonbanks, as discussed directly below. Further the Federal Reserve’s AIG acquisition might have been illegal even under the pre-Dodd–Frank §13(3). Recently the US Court of Federal Claims ruled that the Federal Reserve did not have the power to acquire AIG’s equity in exchange for a §13(3) loan.7 While the ruling may still be overturned on appeal, it nonetheless raises the possibility that Dodd–Frank’s “broad-based program” restriction was unnecessary if the goal was to prevent another AIG-type acquisition by the Federal Reserve. Rather than generally limiting Federal Reserve’s lender-of-last-resort power, §13(3) could instead specify that the Federal Reserve cannot acquire a borrower’s equity. However, strict limitations to the Fed’s ability to customize lending to financial institutions facing insolvency and lacking adequate collateral could be problematic. Under Dodd–Frank programs cannot be tailored to individual situations, as in the cases of Bear and AIG.
Restoring the power to lend to a single solvent institution that was the first victim of a run would not necessarily require new legislation. The Fed could design a broad program available to any solvent nonbank victims of runs, including the first one, and that program could be approved in advance by the Secretary of the Treasury. But in the anti-bailout environment in Washington, DC, such action would be attacked as an attempt to bail out Wall Street. If the Secretary were to authorize a broad program, it is likely she would only do so when faced with the real prospect of another crisis, which could be too late to forestall a run.
On December 23, 2014, the Federal Reserve Board published a proposed rule to amend Regulation A, which covers Extensions of Credit by Federal Reserve Banks, to implement Section 1101 of the Dodd–Frank Act (“Proposed 1101 Rule”), which was the amendment to Section 13(3).8 As part of its proposal, which basically tracked the language of Section 1101 so as to preserve maximum flexibility, the Fed defined a broad program as one that is not designed for a single and specific company.9 On January 13, 2014, Jeb Hensarling, the Chairman of the House Financial Services Committee sent a letter to then Federal Reserve Chairman Bernanke (the “Hensarling letter”), asking for a more precise definition of a broad program and suggested that a maximum borrowing amount be set for an individual firm, going beyond the language of Section 1101.10 This was followed by a later letter, on August 18, 2014, of several members of the House and Senate to Chair Yellen, including Senator Warren, (the “Warren letter”)11 suggesting the possibility that a broad program require more than two recipients (the Fed’s proposal implies that any number greater than one would be broad). These letters are important in two respects. They reflect the hostile political environment facing the Fed’s use of its lender of resort power for nonbanks and seek to put even more restrictions on the Fed than did Dodd–Frank itself, by urging the Fed to refrain from even exercising what reduced authority it now has.
The Fed responded to some of the concerns in its final rule approved on November 30, 2015, however, one could argue the changes are merely cosmetic.12 The final rule defines “broad-based” as a program in which five or more institutions are eligible to participate. The question remains as to how this rule restricts the ability of the Fed to lend to the first nonbank financial institution that experiences a run. Would four other institutions also have to experience a run at the same time or would future risk of a run be sufficient? In the end, the eligibility standard will hinge on the specific conditions of the program. The Fed’s final rule also made additional cosmetic restrictions that are not required under the statute. As part of a 13(3) program, the Fed must disclose publicly the market sector targeted by the 13(3) lending and the Fed will review each program every six months.13
Dodd–Frank also requires that all lending to nonbanks be subject to “the prior approval of the Secretary of the Treasury.”14 The Act requires that the “policies and procedures governing emergency lending” be promulgated in consultation with the Secretary of the Treasury and that, as already discussed, no program or facility under Section 13(3) may be established “without the prior approval of the Secretary of the Treasury.” This provision effectively withdraws exclusive control over the decision to loan to nonbanks from the Federal Reserve Board, an exclusive power it had during the crisis. It severely limits the ability of the Federal Reserve to respond independently to a crisis. The Dodd–Frank Act’s requirements for Treasury approval of Federal Reserve actions will arguably politicize the decision of how to deal with contagion and create significant market uncertainty, thereby accelerating the outbreak and pace of future runs.
In some respects the new requirements recall the early days of the Fed’s existence when political interference with all central banking operations was a serious concern. Economist Allan Meltzer has conducted extensive research on the Federal Reserve’s early struggles to maintain its independence.15 The Federal Reserve was formed just one year before the start of World War I, and Meltzer finds that the Federal Reserve’s early years were spent providing support to the Treasury’s war-financing efforts.16 This arrangement placed the Federal Reserve in a position of relative subservience to the Treasury, symbolized by the fact that the Federal Reserve originally met in a Treasury Department conference room.17 “[T]he Secretary of the Treasury was the ex officio chairman of the Federal Reserve Board until 1935, who sat at the head of the table whenever he chose to attend meetings.”18 In particular, during World War I Federal Reserve officials explained that they allowed inflation risks to rise and rejected rate increases because such increases were “inadvisable from the point of view of Treasury’s plans.”19 The early Federal Reserve was also reluctant to oppose the Treasury in light of the Overman Act, which allowed the President to transfer Federal Reserve responsibilities to another agency (e.g., the Treasury) during the wartime period.20 Overall, Meltzer notes that throughout this early period, congressional officials blamed the Federal Reserve’s missteps on the agency’s lack of independence from political pressures.21 Meltzer concludes that the early Federal Reserve “was too weak politically to slow or stop the postwar inflation and too uncertain about the political consequences of its actions to act decisively when the Treasury allowed it to act.”22 A former vice-chairman of the Federal Reserve, Frederick H. Schultz, has described the period of maximum Treasury involvement with the Federal Reserve’s operations as a time of “politicized” decision-making.
After World War I the Federal Reserve attempted to assert its independence. Certain congressional members supported this endeavor and passed the Banking Act of 1935, a law that further centralized monetary decision-making power in the Federal Reserve.23 The primary objective of the Banking Act was to centralize authority in the Board of Governors and to make permanent some of the temporary exceptional measures discussed above.24 As previously mentioned, the Banking Act expanded the Federal Reserve’s lender-of-last-resort authorities by permitting Section 10(b) lending in other than “exceptional and exigent circumstances.”25 The Act greatly enhanced the Federal Reserve’s independence by removing the Secretary of the Treasury and the Comptroller of the Currency from the Board of Governors.26 Two years prior, the Banking Act of 1933 had established the Federal Open Market Committee (“FOMC”).27 However, the decisions of the FOMC with respect to open market operations were not binding on reserve banks.28 The Banking Act of 1935 placed control of the FOMC in the Board of Governors, by ensuring that a majority of its members were members of the Board of Governors, and by making its decisions about open market operations binding on reserve banks.29
However, Meltzer finds that continued “[s]ubservience to the Treasury during the [post–World War I] recovery … limited the effect of the legislation for a time.”30 Moreover the Federal Reserve returned to a deferential wartime role in the wake of World War II; during this period then Federal Reserve Chairman Marriner Stoddard Eccles characterized his role as “a routine administrative job … [t]he Federal Reserve merely executed Treasury decisions.”31 After World War II the Federal Reserve obtained formal independence through the 1951 Accord, an agreement that freed the Federal Reserve from the Treasury-induced ceiling on interest rates.32 Meltzer notes that subsequent to the 1951 Accord, the Federal Reserve “[f]or the first time since 1934 … could look forward to conducting monetary actions without approval of the Treasury.”33 Federal Reserve independence was thus achieved only after the early Federal Reserve struggled to accede to Treasury instruction. This initial subservience hindered the Federal Reserve’s ability to avoid political concerns and effectively combat shifting market environments.
It is interesting, given the long history of the Fed’s struggle to free itself from control of the Treasury, to look into the legislative history of Dodd–Frank’s new requirement for Treasury approval of Fed lending to nonbanks. The initial proposal for what amounts to a Treasury veto on the Fed’s lender-of-last-resort authority to nonbanks came from the Treasury itself. The Treasury’s June 17, 2009, Final Report on Financial Regulatory Reform, proposed to revise the Fed’s “emergency lending authority to improve accountability,” by requiring Treasury approval.34 Subsequently the Obama administration, on July 22, 2009, introduced draft legislation containing the requirement that the Fed’s emergency lending authority have the “prior written approval of the Secretary of the Treasury.”35 The House Republican bill introduced on July 23, 2009, also contained a requirement for Treasury Secretary approval, as well as a provision to allow for congressional disapproval of §13(3) authority.36 A November 3, 2009, bill by Democratic Representative Barney Frank also contained a requirement of Treasury approval.37 By December 11, 2009, the bill that ultimately became the Dodd–Frank Act, House bill (HR 4173), not only contained a requirement of Treasury Secretary approval of lending programs but also added several further limitations to the Fed’s power of lender of last resort to nonbanks that were not adopted into the Dodd–Frank Act: certification by the President that an emergency exists, FSOC determination that a liquidity event exists, and congressional power to disapprove of any §13(3) program.38 HR 4173 ultimately passed the House, but only after two major recorded votes for resolving differences, and only after passing the Senate.39 The bill that was initially engrossed in the House on December 11, 2009, contained these additional restrictions on the Fed,40 as did the bill that was referred in the Senate on January 20, 2010.41 However, the amendment engrossed in the Senate on May 20, 2010, substantially revised the provisions affecting the Federal Reserve, removing these restrictions.42
Why would the Treasury, headed by a Secretary who previously served as President of the New York Fed, propose such restrictions on the Fed? It is interesting in this regard to note that Geithner in his book Stress Test, while criticizing other restrictions on the Fed imposed by Dodd–Frank, never mentions this one, which arguably is one of the most onerous. The reason is clear: he cannot criticize a provision that he himself sponsored. I asked Secretary Geithner, after he left office, why he did this. He responded that sometimes the Treasury would want the Fed to act as lender of last resort when the Fed was reluctant to do so.43 And that is surely possible—in the crisis Paulson was urging Bernanke on. But requiring the Treasury to approve the Fed acting as lender of last resort does not accomplish that objective—the Treasury must approve the Fed’s request to lend, it cannot order the Fed to lend. As we will see later, the power of Treasury to compel central bank lending does exist, however, in Japan and the United Kingdom.
So what was the real reason that Geithner made this proposal? I believe there are only two plausible reasons. First, this could just be a continuation of the historical battle for supremacy between the Treasury and the Fed. Treasury saw an opportunity to control the Fed and took it. While Geithner had served as president of the New York Fed, he had not been chairman of the Board, and outside his service at the Fed, he was a career Treasury official. A second possibility is that he was trying to forestall even worse outcomes in a Congress that was intent on punishing the Fed for bailing out Wall Street. This is plausible given the congressional proposal to have the power to veto loans to particular nonbanks. In any event, Treasury control of the Fed was not proposed by conservative republicans but by the Obama Treasury itself.
Holders of short-term debt issued by failing financial institutions are extremely unlikely to accept the uncertainty inherent in an ad hoc lending regime that might be canceled at any time or simply never initiated at all,44 especially when the arbiter of the decision is the Secretary of the Treasury, a political appointee, not a an independent agency like the Fed. The risk that the Secretary will withhold lender-of-last-resort assistance from a distressed financial institution at a critical moment prevents this assistance from serving its function as a guarantee, or even a near guarantee.45
In 2008, Secretary Paulson readily gave his support of Federal Reserve lending under 13(3), and would no doubt have given his formal approval if required. Some believe that in the future faced with the extreme consequences of not lending, the Secretary of Treasury, staring over the precipice, will have to give approval. Former Fed Chairman Ben Bernanke, for example, pointed out that “the approval of the Treasury Secretary … is basically okay, for Democratic reasons and because, generally speaking, the Treasury Secretary and the Fed chairman see pretty much eye to eye at trying to prevent the financial system from collapsing.”46 In his recent book, Bernanke further added: “[§13(3)’s ability to lend to individual institutions] was one authority I was happy to lose. We would still be able to use 13(3) to create emergency lending programs with broad eligibility such as our lending program for securities dealers or the facility to support money market funds, although we’d have to obtain the Treasury secretary’s permission first. I didn’t consider that much of a concession, since I couldn’t imagine a major financial crisis in which the Fed and the Treasury would not work closely.” 47 But in the new post-crisis political environment, it is far from certain that Treasury approval will be given at all, or on a timely basis—most important, the market will think it is uncertain, and thus start to run before such a decision is even made. I read Bernanke’s comments as accepting bad restrictions on the Fed in order to fend off even worse ones.
Even if a particular Fed action might be approved by the Treasury Secretary under 13(3), or could be taken for banks without Treasury approval through the discount window, the political environment for the Fed acting as lender-of-last-resort has changed, making it less likely the Fed would even exercise its lender of last resort authority in a crisis. After all, it has been widely criticized for “bailing out Wall Street” in the last crisis. A cornerstone to the Fed’s authority as lender of last resort is its independence from political forces; it is thus worrisome that Ben Bernanke believes Treasury approval may be required in a democracy—would he say the same for monetary policy? Fundamentally, Bernanke’s concession reflects the strong political attack on the power of the Fed as lender of last resort. Arguably, the Fed’s role as a lender of last resort is even more important than its role in conducting monetary policy, so the independence of the Fed as lender of last resort should be a top priority.
Section 13(3) of Dodd–Frank also prohibits the Federal Reserve from providing emergency lending to nonbank financial institutions that are insolvent.48 A borrower is deemed insolvent if the borrower is in bankruptcy, under Orderly Liquidation Authority (OLA) or any other Federal or State insolvency proceeding.49 This, of course, is a central tenet of Bagheot’s rule. However, the rescue of AIG as well as the loan assisting JP Morgan’s acquisition of Bear Stearns seemingly violated this basic principle. In my view, a major consideration in the case of AIG was the fear of compounding the contagion unknowingly unleashed by the decision not to loan to Lehman.
The Fed’s own policy and procedures are set up to take solvency into account in making loans to banks. Discount window lending to depository institutions is governed by Regulation A.50 While the policies and procedures that govern Fed lending decisions depend on the type of discount window lending (i.e., primary credit vs. secondary credit), all decisions involve an inquiry into the solvency of the bank.51 The availability of primary or secondary credit depends on the financial condition of the bank, as described below.
Primary credit is only available to banks that are in “generally sound financial condition in the judgment of the Federal Reserve Bank.”52 To make this determination, Federal Reserve Banks evaluate criteria set forth in the Board of Governors’ Payment System Risk Policy.53 According to these criteria, a bank will be eligible for primary credit provided it has a strong CAMELS rating of one to three (with one being the highest possible rating), it is adequately capitalized, and there is no “supplementary information [that] indicates the institution is not generally sound.”54 The Federal Reserve Banks do not provide public information as to how they determine whether such supplementary information exists. The CAMELS (Capital adequacy, Assets, Management capability, Earnings, Liquidity, Sensitivity to market risks) rating is a score assigned to a bank by its prudential supervisor, and depends on quantitative factors from the bank’s balance sheet and supervisory assessments. A bank with a lower CAMELS rating of four can become eligible for primary credit, provided “supplementary information indicates that the institutions is at least adequately capitalized and that its condition has improved sufficiently to be deemed generally sound by its Reserve Bank.”55 The FDIC Improvement Act sets the legislative framework for bank lending via the secondary credit facility.56 The secondary credit facility is designed for banks that are not “adequately capitalized” and therefore have a CAMELS rating of five. The secondary credit facility can also be used for banks that are “critically undercapitalized.” A bank is critically undercapitalized if it is undercapitalized and does not meet leverage and other requirements set forth by the FDIC.57 Most important, a Reserve Bank can only lend to these banks if “in the judgment of the Reserve Bank, such a credit extension would be consistent with a timely return to reliance on market funding sources.”58 Additional rules also govern Fed lending to undercapitalized and critically undercapitalized banks that generaly limit the timing of discount window loans. For example, a Federal Reserve Bank can only lend to a critically undercapitalized bank within five days of its classification as critically undercapitalized, or after consultation with the Board of Governors.59 These procedures depend critically on supervisory information, which would not generally be available for nonbanks, since only nonbank SIFIs are supervised by the Fed.
But while it may be the policy of the Fed to only loan to solvent institutions (banks as well as nonbanks), until Dodd–Frank there was no statutory prohibition on lending to an insolvent nonbank, and there is still no statutory prohibition on lending to an insolvent bank through the discount window. It is hard to see why there should be a double standard on this issue. It is important to note that a statutory prohibition on lending to an insolvent nonbank is likely to act as a political deterrent against the Fed lending to nonbanks because if the borrower turns out to be insolvent, then Congress will have grounds to be highly critical of the Fed’s decision to lend. The saving grace of the Dodd–Frank prohibition may be the very limited definition of insolvency—a borrower “shall be considered insolvent” under Dodd–Frank §1101(a)(6) if it is in an insolvency proceeding (e.g., bankruptcy). Thus the Fed could take the position in the future that there would no statutory prohibition on lending to an insolvent institution not in such a proceeding.
Indeed both the Hensarling and Warren letters suggest that the term “insolvency” not be limited to firms that are in an insolvency proceeding. And the Hensarling letter asks the Fed to “create a financial metric to determine whether a firm is insolvent,” a demand interestingly not joined in by the Warren letter.60
This revision would deprive the Fed of the latitude that the Dodd–Frank Congress may have granted it. But it should be understood that the Congress after the fact might assert that other institutions are not excluded from the definition of insolvency and that the policy of the statute is broader. Indeed, the Fed’s final November 2015 rule includes a broader definition of insolvency under 13(3); the Fed’s updated insolvency definition includes “potential borrowers that are generally not paying their undisputed debts as they become due during the 90 days preceding borrowing from the program, and potential borrowers that are otherwise determined by the Board or the lending Federal Reserve Banks to be insolvent ... [and] any person in a resolution or bankruptcy proceeding.”61 This possibility could still constrain the Fed and the Secretary of the Treasury in taking any significant risk that a borrower could be determined after the fact to be insolvent. It should be understood that while the prohibition of lending to insolvent borrowers is sound, the distinction between merely illiquid and truly insolvent borrowers, in the midst of financial crises, is difficult to determine, in particular because “liquidity problems rarely if ever hit an isolated intermediary unless there is good reason for lenders to attach at least some probability to insolvency.”62 Moreover, in the midst of a run, it is particularly difficult to value an institution’s assets. Nonetheless, this is a good prohibition, if it is understood that room for judgment exists. While it is possible to lay out general principles regarding solvency requirements, it is impossible to outline specific metrics. The question of Lehman’s solvency at the time of its failure illustrates the problem with specific metrics. Some considering an acquisition, like Bank of America, who inspected Lehman’s balance sheet on Lehman weekend, thought there was a “hole” of substantial size. Yet a reported study of the staff of the Federal Reserve Bank of New York, which then President Geithner of the New York Fed said he never saw, thought Lehman was solvent.63 The valuation of Lehman’s assets was debatable, leaving no clear distinction between solvency problems and liquidity problems at the firm.64 In general, as former Deputy Governor of the Bank of England Paul Tucker has said, a “solvency judgment is inherently probabilistic.”65 I would add that it is also more art than science, particularly when made in real and limited time. Paul Tucker has also suggested that central banks should outline a procedure for making this determination, which might be possible, though it may be difficult to follow a procedure set in advance in cases posing different complexities and time constraints.66
Prior to Dodd–Frank, banks could, without limitation, channel discount window loans to nonbank affiliates (including broker-dealers) through repo transactions or other securities financing transactions. For example, repo transactions were not considered “covered transactions,” so did not fall under the limitations restricting banks from engaging in such transactions with an affiliate to the extent of more than 10 percent of the bank’s capital. However, Dodd–Frank’s revision to Section 23A of the Federal Reserve Act has now subjected such affiliate loans to the normal 10 percent limit. Furthermore, while Section 23A does allow the Federal Reserve to exempt transactions from the 23A restrictions by regulation, Dodd–Frank imposed the requirement that the FDIC not object to the exemption on the grounds that it would pose an unacceptable risk to the Deposit Insurance Fund. The combination of the 10 percent limit, a lack of exception for repo transactions, and an extra hurdle for a possible exemption would pose a significant problem during a contagious run. Affiliates will now have to go to the Fed directly as nonbanks for loans under §13(3), subject to all the new restrictions placed on the Fed.
The impairment of the Federal Reserve’s lender-of-last-resort capabilities is most concerning with regard to broker-dealers.67 A key regulatory concern for broker-dealers and the financial system, in general, is the potential lack of access for large broker-dealers to the Fed discount window, which includes the largest broker-dealers in the United States, as they are affiliates of banks and subsidiaries of bank holding companies. For example, at the end of 2012, based on FDIC and SEC filings, Goldman’s US bank subsidiary had total assets of just $120 billion while Goldman’s US broker-dealer subsidiary had $500 billion in assets. Since the vast majority of Goldman’s assets are not held by a US bank, they cannot be pledged in exchange for a traditional discount window loan from the Fed. Creditors of the broker-dealer are thus subject to the vagaries of the new §13(3) of Dodd–Frank.
The FSOC highlighted the lack of public liquidity for large broker-dealers (even those that are a part of a bank holding company) as a potential emerging threat to the US financial system in its 2013 annual report.68 The report states that “[t]he absence of direct and pre-specified sources of public liquidity and credit backstops makes broker-dealers, as compared to banks, more exposed to vulnerabilities in their funding sources.”69
Collateral policy is at the heart of an effective lender-of-last-resort regime. Under old Section 13(3), as used in the crisis, loans only had to be secured “to the satisfaction” of the Fed. This broad authority was used by the Fed to lend to unsecured commercial paper issuers with high credit ratings but with no collateral. Under the revisions to Section 13(3), “security for emergency loans [must be] sufficient to protect taxpayers from losses” and the “policies and procedures established by the Board shall require that a Federal reserve bank assign consistent with sound risk management practices and to ensure protection for the taxpayer, a lendable value to all collateral for a loan executed by a Federal reserve bank under this paragraph in determining whether the loan is secured satisfactorily for purposes of this paragraph.”70 The 13(3) revisions disallow future Fed use of unsecured commercial paper loans.71 These revisions must be read in conjunction with the power of the Secretary of the Treasury to approve all policies and procedures for lending to nonbanks, so Treasury would also have the ultimate approval over collateral policies.
According to Paul Tucker, it is crucially important that central banks stand ready to lend against a broad range of collateral.72 Despite these changes, there is still significant discretion that can be exercised by the Fed, if approved by the Treasury, to define the types and amounts of acceptable collateral. A broad interpretation might include cases in which the Federal Reserve deems it unnecessary or inexpedient to require collateral from borrowers at all, as in the 2008 financial crisis, during which the Federal Reserve purchased unsecured commercial paper. In addition to determining the types of acceptable collateral, an optimal collateral policy would ensure that appropriate haircuts are applied to discount all forms of collateral, so as to protect the Fed and ultimately taxpayers from loss.
It is not immediately obvious why Fed losses expose taxpayers to loss, since the Fed’s power to create money means it can operate even with negative capital.73 However, losses do mean that the Fed would have fewer profits to send to the Treasury to support the general revenue of the United States, and these profits have been very substantial. Remittances in 2014 were $99.7 billion,74 around 3.3 percent of total US revenue that year.75 Lower contributions to US revenue by the Fed could mean higher taxes or higher US debt. Loans could also impair the Fed’s reputation.
Section 1103 of Dodd–Frank requires that the Fed disclose any §13(3) lending within one year of the effective date of the termination by the Federal Reserve of the authorization of the lending.76 Section 1103 has also revised the disclosure rules related to discount window lending to banks. Under Dodd–Frank, the Federal Reserve is now required to publish the names of all banks that borrow from the discount window and how much they borrowed two years after they access the discount window.77
In addition Section 1101 of Dodd–Frank requires the Fed to provide to the two congressional banking committees the names of nonbank borrowers and the amount and terms of their loans, within seven days of Fed authorization of such loans.78 The Fed can request such information be kept confidential in which case the information will only be given to the chairperson or ranking member of the committees.
As we saw in the crisis, the stigma attached to discount window borrowing (which was not disclosed) motivated banks not to use the window during the crisis even when they needed it.79 Publicly announcing the names and amounts of borrowers might exacerbate the stigma concerns and could increase the likelihood of avoidance, even if such disclosure comes two years later in the case of banks, or one year in the case of nonbanks. A recent paper provides empirical support for the stigma effect, showing that depositors during the Great Depression withdrew more from banks included on a disclosed list compared to those left off of the list. 80 Further the requirement of a seven day reporting of nonbank loans to Congress, even to chairpersons and ranking members, carries with it a risk of leaking, which might further dissuade nonbanks from borrowing.
In my view, a one or two year lag is reasonable, balancing the needs of transparency against the risk of nonborrowing for stigma, but the requirement of a seven-day reporting to Congress puts Congress into micromanaging such loans, which might not only dissuade nonbanks for asking for such loans but make the Fed less willing to make them or to force the Fed to adopt more stringent requirements than they might otherwise do.
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All of these new requirements make the Fed a weaker lender of last resort to nonbanks that play an increasingly important role in our financial system. Nondeposit short-term liabilities represented around 75 percent of total uninsured short-term liabilities at the end of 2014. In 1970 they only represented around 17 percent. Nondeposit liabilities include money market mutual fund shares, commercial paper, repurchase agreements, and securities lending. Because these nonbanks rely on short-term funding, they are exposed to contagious runs.