1 Lender of last resort wrayLesson

2 Bagehot’s principles lending to only solvent banks, against good collateral, and at “high” or penalty rates.

3 Fed’s lending rates We provide a detailed analysis of the Fed’s lending rates and reveal that it did not follow Bagehot’s classical doctrine of charging penalty rates on loans against good collateral. Further, the lending continued over very long periods, raising suspicions about the solvency of the institutions.

4 Others, however, have criticized the Fed as being anything but classical not only in exceeding traditional bounds in the magnitude of its balance sheet expansion but also for rescuing unsound institutions rather than limiting its assistance to solvent but illiquid firms, for accepting worthless collateral in security for its loans, for charging subsidy rather than penalty loan interest rates, and for channeling aid to privileged borrowers rather than impartially to the market in general.

5 Llr policy classicals viewed LLR policy as part and parcel of the central bank’s broader responsibility to protect the stock of bank-created money from contraction (and to expand it to compensate for falls in its circulation velocity).

6 Money protection functionThe central bank fulfills its money protection function by pre-committing to expanding reserves without limit to accommodate panic-induced increases in the demand for money.

7 Avoid to dump assets By creating new reserves on demand for sound but temporarily illiquid banks, the LLR makes it unnecessary for those banks, in desperate attempts to raise cash, to dump assets at fire-sale prices that might render the banks insolvent and would reduce the outstanding supply of bank money (as loans are called in and deposits are debited.)

8 llr Thornton especially, but Bagehot too, understood that the central bank’s distinguishing feature as an LLR consists of its monopoly power to create unlimited amounts of high-powered money in the form of its own notes and deposits, items whose legal tender status and universal acceptance mark them as money of ultimate redemption and the equivalent of gold coin.

9 Special responsibilityUnlike the bank, whose duties extend only to its stockholders and customers, the LLR’s responsibilities extend to the entire macroeconomy. This special responsibility dictates that the LLR behave precisely the opposite of the banker in times of stress, expanding its note and deposit issue and its loans at the very time the bank is contracting.

10 Money view It follows that the LLR must draw a sharp distinction between the asset,or credit (loans and discounts) side, and the liability, or money (notes and deposits) side of bank balance sheets. Although the two aggregates, bank credit and bank money, tend to move ogether, it is panic-induced falls in the latter rather than the former that render damage to the real economy.

11 money Because money forms the transaction medium of final settlement, it follows that its contraction— rather than credit crunches and collapses—is the root cause of lapses in real activity.

12 Central bank To prevent this sequence of events, the LLR must stand ready to accommodate all panic-induced increases in the demand for high-powered money, demands that it can readily satisfy by virtue of its open-ended capacity to create base money in the form of its own notes and deposits.

13 Most recently, in the financial crisis of 2008–09, the Fed adhered to some classicalprinciples, while it departed from others.18 C

14 Evaluation of policy Consistent with the classical model, it provided reserves to the banking system, albeit with some delay and in a rather haphazard manner (as detailed in our 2012 report). These injections were sufficient to resolve the crisis (but insufficient to prevent the recession or to boost the weak recovery even after several rounds of quantitative easing).

15 Quality of collateral What was inconsistent with Bagehot’s advice, however, was that much of this collateral was complex, opaque, hard-to-value, illiquid, difficult to buy and sell, risky, and liable to default—hardly good security. The Fed also purchased outright from banks and other financial institutions assets such as commercial paper, securities backed by credit cards, student loans, auto loans, and other assets, and mortgage-backed securities and debts of GSEs. Finally, it guaranteed debt of Citigroup, and extended loans to insurance giant AIG, both of them insolvent firms deemed too big and too interconnected to fail.

16 departures Emphasis on Credit Instead of Money Taking Junk Collateral.Charging Subsidy Rates Rescuing Unsound Firms Too Big to Fail. Extension of Loan Repayment Schedules No Pre-announced Commitment No Clear Exit Strategy

17 Excess reserves

18

19 The excess arose originally from the Fed’s emergency lending activities after August 008, increasing from less than $2 billion in August to $767 billion by year-end 2008.

20 Quantitative easing Afterward, throughout 2009 and until mid-year 2010, the Fed engaged in the first major quantitative easing program of purchases of government agency debt and agency guaranteed mortgage-backed securities. The Fed’s purchases reached a cumulative total of $1.285 trillion, and excess reserves reached nearly $1 trillion.

21 Reserves use the new reserves provided by the purchases program enabled the banking system to fund the repayment of about $1 trillion of various forms of advances to financial institutions under the emergency lending program. The emergency lending program ended, but quantitative easing replaced it.

22 Second round QE In early 2011, the Fed began its second round of quantitative easing, aimed at purchasing about $600 billion of longer-term Treasury securities. When the program ended in June 2011, $581 billion had been added to excess reserves, with the peak amount reached in July 2011, $1.618 trillion. The peak amount of monetary base that same month was $2.681 trillion.

23 No increase in bank creditThe Fed should have learned from the experience of the quantitative easing programs that its purchases of securities did little or nothing to increase the quantity of bank credit actually supplied to the general economy.

24 QE3 This past September the Fed announced a full-speed-ahead procession with QE3. This time, the Fed promised to buy $40 billion worth of mortgage-backed securities (MBSs) everymonth through the end of the year, and to keep what is essentially a zero interest-rate policy (ZIRP) in place through mid The Fed also announced that it will purchase other long-maturity assets to bring the total monthly purchases up to $85 billion, with the bias toward the long end expected to put downward pressure on long-term interest rates. The Fed made clear that QE3 is open-ended, to continue as long as necessary to stimulate to a robust economic recovery.

25 graph

26 How the fed pays for assetsWhen the Fed buys assets, it purchases them by crediting banks with reserves. The result of QE is that the Fed’s balance sheet grows rapidly—to, literally, trillions of dollars. At the same time, banks exchange the assets they are selling (the Treasuries and MBSs that the Fed is buying) for credits to their reserves held at the Fed. Normally, banks try to minimize reserve holdings—to what they need to cover payments clearing (banks clear accounts with one another using reserves) as well as Fed-imposed required reserve ratios. With QE, the banks accumulate large quantities of excess reserves.

27 Lend out reserves A lot of people—including policymakers—exhort the banks to “lend out the reserves” on the notion that this would “get the economy going.” There are two problems with that thinking. First, banks can lend reserves only to other banks—and all the other banks have exactly the same problem: too many reserves. A bank cannot lend reserves to households or firms because they do not have accounts at the Fed; indeed, there is no operational maneuver that would allow anyone but a bank to borrow the reserves (when a bank lends reserves to another bank, the Fed debits the lending bank’s reserves and credits the borrowing bank’s reserves).

28 … The second problem with the argument is that banks do not need reserves in order to lend. What they need is good, willing, and credit-worthy borrowers.

29 qe What QE comes down to, really, is a substitution of reserve deposits at the Fed in place of Treasuries and MBSs on the asset side of banks. In the case of Fed purchases of Treasuries, this reduces bank interest income—making them less profitable.

30 Effectively, the banks are moving losers off their balance sheets in order to get safe reserves that earn next to nothing. That is a good trade! But, again, it does not induce banks to make more loans, does little to stimulate Main Street, and creates moral hazard in the financial system as it teaches banks an invaluable lesson: too dumb to fail.

31 Rates for top 8 borrowers

32 continues

33 The Fed lent huge volumes of reserves at low interest rates over a very long period. There are two ways of perceiving this. First, it could be seen as an interest rate subsidy to (largely) big banks and to credit markets more generally—a gift provided by the Fed to purportedly solvent institutions. The second possibility is that these institutions were suffering from insolvency, not liquidity problems. They could not borrow at reasonable interest rates in markets, and so the Fed had to lend to them for extended periods to try to restore solvency.

34 Subsidy to insolvent banksLending at low rates to insolvent banks for a sustained period of time (with an average of almost two years) can have the effect of increasing bank profitability. It is of little wonder that the crisis was mitigated after the Fed bought $1.25 trillion in possibly toxic assets.

35 undemocratic By doing so, it not only circumvented the normal functioning of financial markets but it also circumvented the democratic process. Lending at or below market rates, allowing banks to negotiate these rates through auctions, and rescuing insolvent banks has validated not only unstable banking instruments and practices but also has perhaps set the stage for an even greater crisis.

36 No liquidity crisis In addition, the extraordinary extension of the terms of the facilities is not consistent with a liquidity crisis.