A missed opportunity for the Fed

In response to the credit and liquidity crunch that has recently spooked global financial markets, the Federal Reserve reduced, on Friday, 17 August 2007, its primary discount rate from 6.25 percent to 5.75 percent. The discount rate is the rate that the Fed charges eligible financial institutions for borrowing from the Fed against what the Fed deems to be eligible collateral. It is normally 100 bps above the target Federal Funds rate, which is the Fed’s primary monetary policy instrument and which is currently 5.25 percent. We believe that this cut in the discount rate was an inappropriate response to the financial turmoil.

The market failure that prompted this response was not that, given that they have eligible collateral, financial institutions are unable to pay 6.25 percent at the discount window and survive. The problem is that banks and other financial institutions are holding a lot of assets which are suddenly illiquid and cannot be sold at any price. That is, there is no longer a market that matches willing buyers and sellers at a price reflecting economic fundamentals. Lowering the discount rate does not solve this problem, it just provides a 50 bps subsidy to any institution able and willing to borrow at the discount window. Instead of lowering the price at which financial institutions can borrow, provided they have suitable collateral, the Fed should have effectively created a market by expanding the set of eligible collateral and charging an appropriate “haircut” or penalty. Specifically, it should have included financial instruments for which there is no readily available market price to act as a benchmark for the valuation of the instrument for purposes of collateral.

There is no apparent legal impediment to doing this. Allowable collateral includes a wide range of government and private securities, including mortgages and mortgage-backed securities. Indeed, the Federal Reserve Act of 1913 allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any just about any collateral the Fed deems fit.[1] Specifically, if the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five out of seven governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) “notes, drafts and bills of exchange … indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”. The combination of the restriction of “unusual and exigent circumstances” and the further restriction that the Federal Reserve can discount only to IPCs “unable to secure adequate credit accommodations from other banking institutions”, fits the description of a credit crunch/liquidity crisis like a glove.

It is of course essential that moral hazard be minimised. This ‘bail out’ of the illiquid by the Fed should be sufficiently costly that those paying the price would still remember it during the next credit boom, and act more prudently. Second, where no market price is available, the Fed should base its valuation on conservative assumptions about the creditworthiness of the counterparty and the collateral offered by the counterparty. They counterparty should not expect to get 90 cents on the dollar for securities that it could not find a willing private taker for at any price. Third, the highest ‘liquidity haircut’ in the Fed’s arsenal should be applied to this conservative valuation.

The Fed should also enlarge the set of eligible counterparties at the discount windows. This should not just be banks and other depository institutions, but any financial entity that it willing to accept appropriate prudential supervision and regulation. The nature of the supervision and regulation required will differ depending on the nature of the institution. Hedgefunds or private equity funds need different prudential regulation from depository institutions, investment banks or pension funds. At the very minimum, however, transparency grounded in comprehensive reporting obligations should be required of any institution eligible to use the discount window.

At least the Fed did not cut the monetary policy rate (the Federal Funds target which remains at 5.25%). A cut in the Federal Funds target is warranted only if the Fed were to believe that the recent financial market kerfuffles are likely to have a material negative effect on real activity in the US or on the rate of inflation. There is no evidence as yet to support such a view. If and when it happens, the Fed should act promptly. But addressing the problem of illiquid financial markets using the blunt instrument of monetary policy, a cut in the monetary policy rate, would be clear confirmation that the Fed is concerned about financial markets over and above what these markets imply for the real economy. Such regulatory capture would effectively redirect the ‘Greenspan put’ from the equity markets in general to the profits and viability of a small number of financial institutions. It would not be a proper use of public money.

© Willem H. Buiter and Anne C. Sibert 2007

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[1] See David H. Small and James A. Clouse (2004), “The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act”, Board of Governors of the Federal Reserve System Research Paper Series - FEDS Papers 20004-40, July.