Vice Chairman Donald L. Kohn
At the Carleton University, Ottawa, Canada
May 13, 2010
The financial and economic crisis that started in 2007 tested central banks as they had not been tested for many decades. We needed to take swift and decisive action to limit the damage to the economy from the spreading distress in financial markets. Because the financial distress was so deep and pervasive and because it took place in financial markets whose structure had evolved dramatically, our actions also needed to be innovative if they were to have a chance of being effective. Many central banks made substantial changes to traditional policy tools as the crisis unfolded. But the epicenter of the financial shock was in U.S. mortgage markets, with severe effects on many of our financial institutions, and our financial markets had perhaps evolved more than many others. As a consequence, no central bank innovated more dramatically than the Federal Reserve
We traditionally have provided backup liquidity to sound depository institutions. But in the crisis, to support financial markets, we had to provide liquidity to nonbank financial institutions as well. Just as we were forced to adapt and innovate in meeting our liquidity provision responsibilities, we also needed to adapt and innovate in the conduct of monetary policy. Very early in the crisis, it became evident that lowering short-term policy rates alone would not be sufficient to counter the adverse shock to the U.S. economy and financial system. We needed to go further–much further, in fact–to ease financial conditions and thus encourage spending and support employment. We took steps to reinforce public understanding of our inflation objective to prevent the development of deflationary expectations; we provided guidance on the possible future course of our policy interest rate; and we purchased large amounts of longer-term securities, and in the process created unprecedented volumes of bank reserves. Now, careful planning is under way to remove that stimulus at the appropriate time. My discussion today will focus on innovations in both our role as liquidity provider and in our monetary policy tools: their motivation, their effectiveness, and their lessons for the future. 1
The Federal Reserve’s Liquidity Tools
Before the crisis, the implementation of monetary policy was fairly straightforward, and our approach minimized its footprint on financial markets. The Federal Reserve adjusted the liquidity it provided to the banking system through daily operations with a relatively small set of broker-dealers against a very narrow set of collateral–Treasury and agency securities. These transactions had the effect of changing the aggregate quantity of reserve balances that banks held at the Federal Reserve, and that liquidity was distributed by interbank funding markets through the banking system in the United States and around the world. In addition, the Federal Reserve stood ready to lend directly to commercial banks and other depository institutions at the “discount window,” where, at their discretion, banks could borrow overnight at an above-market rate against a broad range of collateral when they had a need for very short-term funding. Ordinarily, however, little credit was extended through the discount window. Banks were able to obtain their funding and reserves in the open market and generally turned to the window only to cover very short-term liquidity shortfalls arising from operational glitches or transitory marketwide supply shortfalls, as opposed to more fundamental funding problems.
During the financial crisis, however, market participants became highly uncertain about the financial strength of their counterparties, the future value of assets (including any collateral they might be lending against), and how their own needs for capital and liquidity might evolve. They fled to the safest and most liquid assets, and as a result, interbank markets stopped functioning as an effective means to distribute liquidity, increasing the importance of direct lending through the discount window. At the same time, however, banks became extremely reluctant to borrow from the Federal Reserve for fear that their borrowing would become known and thus cast doubt on their financial condition. Importantly, the crisis also involved major disruptions of important funding markets for other institutions. Commercial paper markets no longer channeled funds to lenders or to nonfinancial businesses, investment banks encountered difficulties borrowing even on a short-term and secured basis as lenders began to have doubts about some of the underlying collateral, banks overseas could not rely on the foreign currency swap market to fund their dollar assets beyond the very shortest terms, investors pulled out from money market mutual funds, and most securitization markets shut down. These disruptions to financing markets posed the same threats to the availability of credit to households and businesses that runs on banks created in the more bank-centric financial system of the 1800s and most of the 1900s. As a result, intermediaries unable to fund themselves were forced to sell assets, driving down prices and exacerbating the crisis; moreover, they were unwilling to assume the risks necessary to make markets in the debt and securitization instruments that were critical channels supporting household and business borrowing–and households and businesses unable to borrow were thus unable to spend, thereby deepening the recession.
These liquidity pressures were evident in nearly every major country, and every central bank had to adapt its liquidity facilities to some degree in addressing these strains. At the Federal Reserve, we had to adapt somewhat more than most, partly because the scope of our activities prior to the crisis was fairly narrow–particularly relative to the expanding scope of intermediation outside the banking sector–and partly because the effect of the crisis was heaviest on dollar funding markets. Initially, to make credit more available to banks, we reduced the spread of the discount rate over the target federal funds rate, lengthened the maximum maturity of loans to banks from overnight to 90 days, and provided discount window credit through regular auctions in an effort to overcome banks’ reluctance to borrow at the window due to concerns about the “stigma” of borrowing from the Federal Reserve. We also lent dollars to other central banks so that they could provide dollar liquidity to banks in their jurisdictions, thus easing pressures on U.S. money markets. As the crisis intensified, however, the Federal Reserve recognized that lending to banks alone would not be sufficient to address the severe strains affecting many participants in short-term financing markets. Ultimately, the Federal Reserve responded to the crisis by creating a range of emergency liquidity facilities to meet the funding needs of key nonbank market participants, including primary securities dealers, money market mutual funds, and other users of short-term funding markets, including purchasers of securitized loans.2
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