The Federal Reserve: The Weakest Lender of Last Resort Among Its Peers

• Date: 01 December 2015
• DOI: http://doi.org/10.1111/infi.12075
• Author: Hal S. Scott
• Published date: 01 December 2015

The Federal Reserve: The

Weakest Lender of Last Resort

Among Its Peers

Hal S. Scott

Nomura Professor of International Financial Systems, Harvard Law School.

Abstract

This article for the first time compares the Federal Reserve’spowersas

lender of last resort (‘LLR’) and its ability to fight contagion, with its

three major peers, the Bank of England (the ‘BOE’), the European Central

Bank (the ‘ECB’) and the Bank of Japan (the ‘BOJ’). It concludes that

the Federal Reserve (the ‘Fed ’) is currently the weakest of the four, largely

due to a hostile political environment for LLR powers, which are equated

with bailouts, and restrictions placed by the 2010 Dodd–Frank Act on the

Fed’s ability to loan to non-banks, whose role in the financial system is

ever-increasing. This is a concern for the global as well as the US financial

system, given the economic importance of the United States and the use

of the dollar as a reserve currency.

I. Background: The Fed and Dodd–Frank

The Fed’s primary LLR authorities are set forth in Sections 10B and 13(3) of the

Federal Reserve Act (‘FRA’). Section 10B authorizes th e discount window, through

I would like to thank Megan Vasios, John Gulliver and Brian Johnson for their ge neral research

assistance. This ar ticle forms the basis of a c hapter in a forthcoming book a bout connectedness and

contagion to be publishe d by MIT Press in spring 2016.

International Finance 18:3, 2015: pp. 321–342

DOI: 10.1111/infi.12075

© 2015 John Wiley & Sons Ltd

which the Fed extends short -term collateralize d loans to depositor y institution s with

reserves at the Fed. At the time of the 2008 crisis, §13(3) permitted the Fed to l end

to non-banks ‘in unusual and exigent circumstances’. On 1 4 March 2008, the Fed

(2014a) used §13(3) to extend a $12.9 billion sec ured bridge loa n to Bear Stearn s

through JPMorgan Chase Bank (‘JPMC’), and then two days later authorized an

additional $29 billion loan to facilitate JPMC ’s acquisition of Bear S tearns. The Fed

(2008a, 2008b) later used §13(3) in September 2008 to provide $85 billion to AIG.

Section 13(3) was further invoked to establish general lending facilities for non-

banks,

1

and to provide liquidit y to money mar ket funds, commercia l paper issuers

and securitizat ion markets.

The Fed relied on its §13(3) authority to provide individual loans and general

market liquidity to non-banks during the 2008 financial crisis. Non-banks require a

strong LLR because their share of runnable short-term liabilities (liabilities of 30 days

or less without a government guarantee) in the banking system has been growing. I

estimate that the US financial system has approximately $7.4 to $8.2 trillion in

runnable short-term liabilities. Non-banks have issued approximately 60% of this total.

In 2010, the Dodd–Frank Act (US House 2010) amended §13(3) to impose

restrictions on the Fed ’s power as LLR to non-banks . These limitati ons hold that

(i) loans cannot be made to single institutions –they must be pa rt of a broad

programme approved by the US Secreta ry of the Treasury; (ii) all non- bank loans

must be approved by the Secretary of the Treasury; ( iii) loans can only be made to

solvent non-banks; (iv) d iscount-window loans to ba nks cannot be used to fund

broker–dealer affiliates; (v) loans must meet heightened collatera l requirements; and

(vi) loans must b e publicly disclosed w ithin one year and disclosed to Congressi onal

leaders within s even days.

This article rev iews the powers of the Fed’s three pe er banks (the BOE, ECB a nd

BOJ), then comp ares these powers wi th those of the Fed an d concludes wit h

observations about the differences .

II. The Bank of England

The BOE was formed as a private corporation in 1694 by royal charter. The Bank

assumed its LLR role gr adually, but by the end of the 19th centur y, the ‘promotion

of financial stability through its role as the effective LLR’was among the BOE’s

informal responsibilities (Carney 2014).

The BOE was nationalized in 1946, and its independent responsibility for

monetary policy was codified in 1998 (BOE, ‘Bank of England Legislation’,n.d.;

1

For example, the Fed (20 14b, 2014c) establi shed the Primary D ealer Credit Facility a nd Term

Securities Le nding Facility i n March 2008 to provide liqu idity to broker–dealers that acted as

counterparties to the Fed’s open market operations.

322 Hal S. Scott

© 2015 John Wiley & Sons Ltd