Since its inception in 1913, the Federal Reserve has had the ultimate responsibility of functioning as a Lender of Last Resort (LOLR). Since then, this LOLR function, along with the rest of the Fed’s toolkit, has undergone a quantum leap in evolution (see conceptual illustration below). Furthermore, functions that have traditionally not been associated with the Fed, like Buyer of Last Resort (BOLR), have been implemented but to our knowledge practical attempts to educate market participants on the differences between the two has been lacking.
The Fed’s actions, whether directly or indirectly, can provide a liquidity backstop to risk assets1 during periods of financial duress. A lack of a full understanding of the intent and administration behind Fed actions can cause investors to miss opportunities when allocating their capital. In this discussion, we will review:
- LOLR refresher
- The evolution of LOLR
- How the 13(3) provision ushered in BOLR
- Classification of Fed facilities into LOLR vs BOLR
- Implications of these expanded Fed functions
Lender of Last Resort (LOLR)
Why does this function exist?
Prior to the establishment of the Fed (and later deposit insurance), the history of the U.S. was marked by bank panics. The panic of 1907 was the last straw and led to the ratification of the Federal Reserve Act in 1913. Allowing the Fed to act as LOLR was a way to restore confidence in the financial system when it was most needed. Banks can be fragile institutions, even those with pristine balance sheets, rock-solid underwriting, and ethical management teams are susceptible to runs. This is because banks are fundamentally engaged in the business of fractional reserve lending and maturity transformation. Banks take in deposits, which are short-term liabilities, and lend out most of these deposits as long-term assets. The bank can only function if depositors have confidence that their deposits will be available to them on demand. If depositor confidence declines, for whatever reason, banks cannot easily liquidate their assets to meet their short-term liabilities. Runs by depositors beget more runs and, in these situations, banks will need a “bank of banks” to extend emergency liquidity after exhausting other funding options. The Fed’s LOLR function exists to serve this exact purpose and is critical to supporting our banking system.
Discount window
Any solvent depository institution in need of emergency liquidity can turn to the Fed’s discount window. Banks must post collateral with the Fed, and the Fed extends short-term liquidity at a rate slightly higher than the Fed Funds rate (although the Fed can adjust this rate and term if needed). The discount window has undergone several enhancements to mitigate the stigma associated with discount window lending. Despite the Fed not reporting borrower details in real-time, banks fear that their activity at the discount window will be discerned by the market. Since borrowing from the discount window is a last resort, depositors and bank counterparties may lose confidence in the bank and withdraw their activities. Because of this stigma, the discount window is less effective than it could be, and attempts to improve this have had little success.
During the GFC, the St Louis Fed noted that “as concerns about bank conditions increased over the course of the financial crisis, the problems associated with stigma may have intensified. This likely resulted in significantly more stress in the interbank funding markets and tighter financial conditions than might have existed otherwise, in addition to more financial contagion.”
The Fed created a better solution in December 2007 with the introduction of the Term Auction Facility (TAF), which allocated funds through auctioning and involved multiple participating institutions. This solved the stigma associated with the discount window and proved to be an effective solution to mitigate broad-based stress in the banking system. Although idiosyncratic issues that arise in the future will still see banks heading to the discount window, if the distress becomes widespread the Fed can quickly create funding programs to address the issue. For instance, the Fed created the Bank Term Fund Lending Program (BTFP2) in 2023 to address regional banking liquidity needs. Both TAF and BTFP are modern species of traditional discount window lending and fall under the Fed’s LOLR functions.
Beyond the discount window
While there have been improvements in how the discount window functions are administered, the function is essentially unchanged in spirit since 1913. What has changed is the financial system has outgrown the banking system. Most lending (and debt) is now being extended (and held) outside of depository institutions. New financial innovations like securitization have enabled a majority of credit to be held outside the traditional banking system. According to the Fed’s data, in 1980, 69% of the US credit market was held by banks, but by 2008, it was only 36%. These non-traditional lenders act in many of the same ways as banks, but without any formal regulatory support. Investment banks, money market funds, mortgage lenders, and other intermediaries all fall under the popular term “shadow banking” (which we use regrettably, as there is nothing sinister or disreputable about these actors).
Since the shadow banking system had not experienced a collective crisis, regulators had not seriously considered how to regulate it. Regulation tends to move slowly and is constructed with a backward-looking lens. It is difficult to provoke policymakers to agree to fix something unless the problem has already surfaced. Our political system is an apparatus that is sustained by garnering credit from the public. Unfortunately, policymakers are almost never extended credit when they are busy fixing the unseen problems of tomorrow. Only when the Great Financial Crisis began to painfully reveal that these shadow banks are essential pillars of the modern financial system did the Fed scramble to find ways to support it. This led to the invocation of a then-obscure 13(3) provision.
Lending to non-banks and the 13(3) Provision
Shortly after the passage of the Federal Reserve Act, it was amended to allow the Fed to lend money to non-banks under exigent circumstances. This provision had been used only once before 2008, between 1932 and 1936, when loans totaling only $1.5 million (roughly $28 million in today’s dollars) were extended. For the next 70 years, lending pursuant to 13(3) remained dormant until it was revived with a vengeance in 2008. During the GFC, the Fed used this provision to extend liquidity to several shadow banking institutions on an individual and broad basis. The Fed created a number of lending facilities under 13(3) to address the funding needs of different classes of borrowers. The creation of these facilities allowed the Fed to support financial markets in novel ways. Although it is common for the Federal Reserve to work closely with the Treasury during emergency times, the Fed did not need formal approval from the Treasury to invoke this provision until the Frank Dodd reforms were implemented. Now, any invocation of 13(3) requires formal approval by the Treasury Secretary.
Buyer of Last Resort (BOLR)
13(3) ushers in BOLR
The Federal Reserve Act of 1913 prohibits the Fed from buying securities that are not “guaranteed or insured” as this would expose the Fed to risk and potentially undermine public confidence in the central banking institution and its ability to support the economy. By mandate, the Fed is not allowed to purchase assets such as corporate bonds, municipal bonds, or equities. However, in 2008, the Fed found a clever workaround through the invocation of 13(3), which permits the Fed to lend to non-banks. Thus, if the Fed wants to buy assets outside its mandate, it lends money to a special purpose vehicle or LLC, which, with the help of Treasury backing, then purchases the targeted securities. All of this maneuvering is to circumvent the legal mandate that prevents the Fed from buying risk assets, which is why the Fed will never directly admit to “buying” these securities. Fed speak for this is that they are “extending liquidity provisions” as they did when announcing their actions in the corporate bond market during the COVID pandemic.
When one buys a security, they are engaging in a transaction that transfers the ownership of existing securities to themselves. Lending, on the other hand, involves providing capital for new borrowing needs. From the Fed’s perspective, buying securities is more useful in directly stimulating targeted areas of capital markets that are under heavy stress, while lending is more useful in helping to unfreeze credit in the real economy by assisting companies in meeting short-term liquidity needs and helping financial institutions continue to make home, consumer, and business loans.
The Fed acts as a BOLR when certain risk assets are in a state of shock, as was the case in 2008 and 2020. Our economy is so dependent on financial markets that Main Street often catches a cold from Wall Street. The flow of credit is essential to the functioning of the economy, and the simple announcement from the Fed that it will be “extending liquidity provisions” to distressed areas of the credit market usually has the immediate effect of reducing panic and allowing credit to flow more easily. Due to this phenomenon, take-up rates for facilities tend to be far lower than originally intended. As Ben Bernanke once admitted, the Federal Reserve is “98% talk and 2% action.”
All the below facilities deployed during the onset of the COVID pandemic were pursuant to 13(3) and, due to changes put forth by the Frank Dodd legislation, must have explicit approval from the Treasury Secretary. Facilities intended to buy securities in the open market are marked as BOLR, while facilities intended to provide direct lending to borrowers are designated as LOLR. It is important to note that the announcement of several facilities predates the passage of the CARES Act, which indicates that although 13(3) invocation requires Treasury approval, if the facilities are revised versions of ones the Fed has already created, the Fed has the authority to establish these facilities without the need for congressional action.
Although the Fed also acted in a BOLR capacity during the GFC, it did so in a more idiosyncratic way than during COVID (namely, through LLCs created to purchase toxic assets from Bear Sterns and AIG). Post-GFC, Frank Dodd regulations reduced the Fed’s ability to be selective, and their BOLR actions during COVID are more indicative of how similar actions in the future would be implemented.
Implications
At Pernas Research, we maintain an internal portfolio consisting of concentrated positions on stocks we research. Readers may wonder why we spend so much time researching the Federal Reserve. After all, what does the Fed have to do with stock research? We allocate precious research time away from stock research with the objective of supplementing our stock-picking with portfolio-managing abilities. Our research into the Federal Reserve is driven by practical origins and reflects how the world has changed. If we had started our research outfit 30 years ago, a thorough understanding of the Federal Reserve would not have been necessary as they did not matter that much. However, today, the Fed, along with other central banks across the world, wields enormous influence, and market psychology is intertwined with every decision they make. As Alex Wolman, vice president for monetary and macroeconomic research at the Richmond Fed, stated, “If markets know the Fed can be relied upon as a liquidity backstop, the Fed can nip market disruptions in the bud.” The market has learned that if the Fed is committed to providing liquidity to areas of the market that have tumbled, the tumbling will stop. Therefore, the only question market participants have to ask is what type of crises cause the Fed to act, and more specifically, what does the reaction function look like that triggers its LOLR and/or BOLR actions? What we are saying has significant implications and flies in the face of conventional market wisdom: In certain instances, a correct understanding of the Fed’s toolkit and its reaction function allows investors to time markets.
The scope of these writing covers the Fed’s toolkit, and a complete understanding of the Fed’s reaction function will involve the political realm. Although we don’t have much to offer in terms of political advice, it’s important to note that Congress holds authority over the Federal Reserve. Therefore, 13(3) actions the Fed wishes to take that are politically distasteful are unlikely to be granted easy approval from the Treasury. When political uncertainty replaces market uncertainty, waiting for clarity from the former may not be a bad strategy.
Recap
- Traditional LOLR functions involve variations of discount window lending to banks and is conducted at the discretion of the Fed.
- Novel LOLR functions lend to the Shadow Banking system and is pursuant to 13(3) and requires Treasury approval.
- BOLR is a brand-new creation that has never before existed in the Fed’s operations. It is pursuant to 13(3) and requires Treasury approval.
- BOLR involves the buying of risk assets and is a more direct (and effective) way to stimulate financial markets.
Footnotes:
1Risk assets” are defined as any securities that are not government backed or insured.
2BFTP – This was launched with the approval of the Treasury in March 2023. We find it curious that even though this falls well within the Fed’s LOLR function they decided to gain formal support from the Treasury. This is telling of the increased political pressure the Fed is facing.
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