THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 490

458 PA R T V Central Banking and the Conduct of Monetary Policy INSIDE THE CENTRAL BANK Federal Reserve Lender-of-Last-Resort Facilities During the Subprime Financial Crisis In the U.S., the onset of the subprime financial crisis in August of 2007 led to a massive increase in Federal Reserve lender-of-last-resort facilities to contain the crisis In mid-August 2007, the Federal Reserve lowered the discount rate to just 50 basis points (0.5 percentage points) above the federal funds rate target from the normal 100 basis points In March 2008, it narrowed the spread further by setting the discount rate at only 25 basis points above the federal funds rate target In September 2007 and March 2008, it extended the term of discount loans: Before the crisis they were overnight or very short-term loans; in September the maturity of discount loans was extended to 30 days and to 90 days in March In December 2007, the Fed set up a temporary Term Auction Facility (TAF) in which it made discount loans at a rate determined through competitive auctions This facility carried less of a stigma for banks than the normal discount window facility It was more widely used than the discount window facility because it enabled banks to borrow at a rate less than the discount rate and because the rate was determined competitively, rather than being set at a penalty rate While the TAF was a new facility for the Fed, the European Central Bank already had a similar facility The TAF auctions started at amounts of $20 billion, but as the crisis worsened, the amounts were raised dramatically, with a total outstanding of over $400 billion On March 11, 2008, the Fed created the Term Securities Lending Facility (TSLF), in which it would lend Treasury securities to primary dealers for terms longer than overnight, as in existing lending programs, with the primary dealers pledging other securities The TSLF s purpose was to supply more Treasury securities to primary dealers so they had sufficient Treasury securities to act as collateral, thereby helping the orderly functioning of financial markets On the same day, the Fed authorized increases in reciprocal currency arrangements known as swap lines, in which it lent dollars to foreign central banks (in this case, the European Central Bank and the Swiss National Bank) in exchange for foreign currencies so that these central banks could in turn make dollar loans to their domestic banks These swap lines were enlarged even further during the course of the crisis On March 14, 2008, as liquidity dried up for Bear Stearns, the Fed announced that it would in effect buy up $30 billion of Bear Stearns s mortgage-related assets in order to facilitate the purchase of Bear Stearns by J.P Morgan.* The Fed took this extraordinary action because it believed that Bear Stearns was so interconnected with other financial institutions that its failure would have caused a massive fire-sale of assets and a complete seizing up of credit markets The Fed took this action under an obscure provision of the Federal Reserve Act, section 13(3), that was put into the act during the Great Depression It allowed the Fed under unusual and exigent circumstances to lend money to any individual, partnership, or corporation, as long as certain requirements were met This broadening of the Fed s lender-of-last-resort actions outside of its traditional lending to depository institutions was described by Paul Volcker, a former chairman of the Federal Reserve, as the Fed going to the very edge of its lawful and implied powers The broadening of the Fed s lender-of-lastresort activities using section 13(3) grew as the crisis deepened On March 16, 2008, the Federal Reserve announced a new temporary credit facility, the Primary Dealer Credit Facility (PDCF), under which primary dealers, many of them investment banks, could borrow on similar terms to depository institutions using the traditional discount window facility On September 19, 2008, after money market mutual funds were subject to large amounts of redemptions by investors, the Fed announced another tempo(continued)