We took a close look at a new Federal Reserve draft document, “Extensions of Credit by Federal Reserve Banks,” issued December 23, 2013. This draft codifies Dodd-Frank Section 1101, which clarifies the Fed’s emergency lending authority. In theory, this is supposed to reduce risk for the public and taxpayers by keeping the Fed from lending to individual firms. But in reality, does the Fed’s proposal really change anything?
Here’s a short summary of the draft rules:
– The Fed can authorize emergency lending if “unusual and exigent circumstances exist.”
– “Credit may be extended by any Reserve Bank only through a program or facility with broad-based eligibility.” No fair creating a preference for any one firm. Broad based eligibility is defined as providing liquidity and can not help a failing or restructuring company (that might go to the Orderly Liquidation Authority).
– The Fed Board needs to document its justification.
– The Fed needs good collateral for any loan.
– There needs to be an exit plan.
We have no issue with the Fed’s role as lender of last resort; in fact, we think it is important. But we did have an issue with the randomness of the Fed’s lending decisions in 2008 (Yes to AIG but No to Lehman?). In the new rules, we don’t see an end to that randomness, just a greater codification of how the random decision gets made. For example, if a big firm might go out of business with awful consequences, the Fed is going to lend. To an individual firm. Because it could cause systemic damage. What’s the difference between that rule and the rule that just lets the Fed lend to the individual firm? Its a gradation of perceived severity, which does not seem to us much different than 2008.
In a private training we gave last summer on securities lending, we had a back and forth with a participant about the role of the Fed as lender of last resort. I said that the Fed would still be there for Financial Market Utilities, then the participant pointed out new pushes from the Fed that CCPs in particular find alternative sources of liquidity (see our write up on the matter here. The participant was absolutely right that the Fed wants out of the game. But the new Section 1101 rules say the opposite: the Fed will still be there, just more people have to opine on the seriousness of the situation to warrant emergency lending.
We think that there is a benefit to more explicit rules surrounding Fed emergency lending; the Section 1101 rules are not for naught. But we don’t think that they yet change the way the game is played to any meaningful degree.
Our suggestion is to create quantitative metrics of systemic risk (interconnectedness in the financial system being one of them) that could not be managed without Fed intervention in case of trouble, then work to reduce those risks to the point where the Fed could proactively say that they will only lend in an emergency to X, Y and Z players because of their degree of systematic risk to the markets. If the markets knew who was eligible for a bail out and who wasn’t, and why, we think that would make some real change.
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Josh, on your last point and recommendation, do you not think that the Fed publishing a list of those firms it would be prepared to “bail out” would lead to a significant market distortion arising from the “advantages” provided for those firms with an explicit safety net? I would be concerned that such firms would see this as a licence to think less seriously about the risks they take. Thoughts? David
David, I agree that a public list would cause a distortion, and what a mess that would make indeed. I was thinking more that the Fed would create a list for internal use and work off of it as a reference for limiting the possibilities for emergency lending. My line about “if the markets knew” was meant to say that the markets would know that such a list existed, not that any one firm or another should be seen as protected. Thanks for bringing this up. Josh