21.2 Crowding Out by the Federal Reserve
21.2.6 Adverse Consequences of Partial and Full Crowding Out via RRP
If the Fed sought to avoid conflicts with monetary policy, by only using its RRP program to the extent of $2.6 trillion, the remaining $1.7 trillion in short-term debt (we assume total private short-term debt is $4.3 trillion) is still vulnerable to contagion. Thus, while the system would be less vulnerable to contagion ex ante, we will still need to be prepared to deal with it if it still occurs.
But even partially crowding out private-sector issuance raises a number of concerns. If public short-term debt issuance expands during a crisis, as opposed to before a crisis, it may create destabilizing effects for the residual private-sector issuance. Specifically, the expanding public issuance could exacerbate runs by allowing for “disruptive flight-to- quality flows during a period of financial stress and thus could undermine financial
stability.”43 It is the rapid change of money market investors from private to public short- term funding that would be destabilizing,44 since the sudden lack of funding sources may leave private institutions incapable of rolling over their debt.45
Further, if the Fed ultimately does succeed in crowding out enough private-sector
issuance to appreciably lower contagion risks, the increase in liabilities from newly issued debt will require an increase in assets. In other words, the Fed will have to decide which securities to invest in on the left-hand side of its balance sheet as the liabilities increase on the right-hand side. Should it buy corporate commercial paper or corporate bonds?
And if so, from which companies? There would also be the question of what
counterparties the Fed would enter into RRPs with on the right-hand side of its balance sheet, raising fairness concerns and concerns about the appropriate role of government in a capitalist system.
In addition there would be the impact on financial institutions that must now replace the short-term debt absorbed by the Fed with longer term debt at higher cost. The impact to those entities no longer able to obtain short-term funding could be particularly
damaging because certain valuable activities for the economy should in fact be funded with short-term liabilities. Broker-dealers fund very short-term assets with short-term liabilities, and this makes economic sense. We may make the system safer from
contagion but at what cost?
Moreover, if the Fed did expand its balance sheet to appreciably crowd out private
issuance,46 the assets it adds would have to bear enough interest to finance payments on RRP. As a result the Fed may have to take on additional balance sheet risk. If the Fed
invests in assets that lose value, or if they do not earn sufficient interest, Fed remittances to the Treasury would decrease and taxes or higher deficits would have to make up the difference.
An expanded balance sheet also raises questions about political economy. The average federal funds rate since 1954 is slightly above 5 percent. If the Fed paid this rate on $8.1 trillion of liabilities, this would amount to around $405 billion in interest payments annually. This is comparable to the Department of Defense’s $496 billion budget in
2014.47 Interest payments on this scale may be difficult to defend in the current political climate questioning the role of the Fed in general, and may therefore further jeopardize the Fed’s independence.
My conclusion is that measures to limit short-term funding, particularly through the Fed, deserve further study. The costs of replacing this cheaper short-term funding with more expensive long-term funding, which may not be optimal for particular activities, such as broker-dealer activities, should also be examined. But for now, it would seem highly unlikely that short-term debt issued by the private sector could be sufficiently reduced to obviate the need for a strong lender of last resort and flexible guarantee system.
Notes
1. Treasury Direct, Historical debt outstanding—Annual 2000–2014, available at http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm;
Treasury Direct, The debt to the penny and who holds it (Mar. 2015), available at http://treasurydirect.gov/NP/debt/current.
2. See Treasury Direct, Historical debt outstanding—Annual 2000–2014, available at http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm 3. Treasury Direct, Treasury bills (2015), available at
https://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm.
4. See Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein, A comparative- advantage approach to government debt maturity, J. Fin. 6; figure 1, panel A at 44 (forthcoming) (2015).
5. Id. at 38.
6. US Treas. Dept., Major foreign holders of Treasury securities (2015), available at http://www.treasury.gov/ticdata/Publish/mfh.txt.
7. Id.
8. http://www.treasury.gov/ticdata/Publish/mfhhis01.txt.
9. Assumes that all maturing debt is re-issued in T-Bills and that projected future deficits are also financed through T-bill issuance. Current maturity profile and deficit
projections obtained from Office of Debt Management, Treasury Presentation to TBAC 1, 26 (2015), available at http://www.treasury.gov/resource-center/data-chart-
center/quarterly-
refunding/Documents/February2015CombinedChargesforArchives.pdf.
10. See Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein, A comparative- advantage approach to government debt maturity, J. Fin. 1 (forthcoming) (2015).
11. Id. at 1.
12. US Treas. Dept., Resource Center: Historical Treasury rates, 30-year nominal rates from 1990–2015 (Mar. 7, 2015), available at http://www.treasury.gov/resource- center/data-chart-center/interest-rates/Pages/Historic-LongTerm-Rate-Data- Visualization.aspx.
13. Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein, A comparative-advantage approach to government debt maturity, J. Fin. 6 (forthcoming) (2015).
14. This presents a greatly simplified synopsis of George Kahn, Monetary policy under a corridor operating framework, Kansas City Fed. Res. Rep. 1 (2012), available at
http://www.kc.frb.org/publicat/econrev/pdf/10q4Kahn.pdf.
15. Josh Frost et al., Overnight RRP operations as a monetary policy tool: Some design considerations (Fed Working Paper 2015–010), available at
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf.
16. Federal Reserve Bank of New York, Federal funds data (2015), available at http://newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm.
17. George Kahn, Monetary policy under a corridor operating framework, Kansas City Fed.
Res. Rep. 1 (2012), available at
http://www.kc.frb.org/publicat/econrev/pdf/10q4Kahn.pdf.
18. Id.
19. Federal Reserve, Aggregate reserves of depository institutions and the monetary base
—H.3 (2015), available at http://www.federalreserve.gov/releases/h3/current/.
20. Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie Remache, Overnight RRP operations as a monetary policy tool: Some design
considerations (Fed Working Paper 2015–010), available at
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf.
21. Id.
22. See Benjamin Friedman and Kenneth Kuttner, Implementation of monetary policy:
How do central banks set interest rates? Handbook of Monetary Economics, vol. 3B, 2011.
23. Todd Keister and James McAndrews, Why are banks holding so many excess reserves? Fed. Res. Bank of New York (Jul. 2009), available at
http://www.newyorkfed.org/research/staff_reports/sr380.pdf.
24. “While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react.” Id. at 2.
25. Id. at 7.
26. Fed. Res. Bank of New York, RRP counterparty eligibility criteria (Nov. 12, 2014), available at http://www.newyorkfed.org/markets/RRP-Counterparty-Eligibility- Criteria.html.
27. Id; see also list of 164 RRP counterparties at Federal Reserve Bank of New York, Reverse repo counterparties list (2015), available at
http://www.ny.frb.org/markets/expanded_counterparties.html.
28. Federal Reserve Bank of New York, FAQs: Overnight reverse repurchase agreement operational exercise (Jan. 14, 2015), available at
http://www.newyorkfed.org/markets/rrp_faq.html.
29. Josh Frost et al., Overnight RRP operations as a monetary policy tool: Some design considerations 5 (Fed Working Paper 2015–010), available at
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf.
30. This would convert “excess” reserves to required reserves. Todd Keister and James McAndrews, Why are banks holding so many excess reserves? Fed. Res. Bank of New York (Jul. 2009), available at
http://www.newyorkfed.org/research/staff_reports/sr380.pdf.
31. Fed. Res. Bank of New York, Temporary open market operations (2015), available at http://www.newyorkfed.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE.
32. Mark Carlson, Burcu Duygan-Bump, Fabio Natalucci, William R. Nelson, Marcelo Ochoa, Jeremy Stein, and Skander Van den Heuvel, The demand for short-term, safe assets and financial stability: Some evidence and implications for central bank policies (Fed Working Paper 2014), available at http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=2534578 (finding that “reverse repo agreements with the central bank are very similar to Treasury bills as a form of public supply of [short-term debt] and can … lower the incentives to issue [short-term debt]”)
33. Josh Frost et al., Overnight RRP operations as a monetary policy tool: Some design considerations 1 (Fed Working Paper 2015–010), available at
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf.
34. Id.
35. Id. at 12.
36. Id. at chart 4.
37. Id. at 1.
38. Id. at 12.
39. Id. at 7.
40. Liz McCormick and Matthew Boesler, The Fed still needs to figure out how to raise rates, Bloomberg (Mar. 25, 2015).
41. Friedman, supra note 1350.
42. Josh Frost et al., Overnight RRP operations as a monetary policy tool: Some design considerations, chart 4 (Fed Working Paper 2015–010), available at
http://www.federalreserve.gov/econresdata/feds/2015/files/2015010pap.pdf.
43. Id. at 12.
44. Id. at 14.
45. In theory, “borrowers who rely on funding from lenders that are more likely to run because of access to an ON RRP facility could reduce this risk by increasing the term of their funding.” Id. at 15.
46. Carlson et al. (2014) discuss options to crowd-out short-term funding without greatly expanding the size of the balance sheet.
47. US Dept. of Defense, Overview (Mar. 2014), available at
http://comptroller.defense.gov/Portals/45/Documents/defbudget/fy2015/fy2015_Budget_Request_Overview_Book.pdf
V Public Capital Injections into Insolvent Financial Institutions
This part focuses on public capital injections into banks, which for short we will call
“bailouts,” as distinct from liquidity support from the Federal Reserve or deposit or short- term liability insurance. While the central bank’s role as lender of last resort is well
established, bailouts are more controversial. As Bernardo, Talley, and Welch (2011) suggest, prior to 2007 most academic economists viewed government bailouts as
“aberrations of developing countries, artifacts of political patronage, or idiosyncrasies of the banking industry.”1 Significant academic skepticism remains “about the wisdom of bailouts as a categorical matter.”2 However, as with TARP, bailouts are realistically the lesser of two evils, if economic collapse is the alternative.
While central bank liquidity and guarantees should be the first line of defense against contagion, one may still need to deal with the negative economic impact of the failure of large banks. Such multiple failures can arise due to correlation risk, the same negative external event, such as a sharp decline in housing prices. The first line of defense against insolvency is capital or increased TLAC to allow resolution, but even higher capital
requirements or TLAC may be insufficient to protect the system against widespread, steep losses. While one can possibly envision resolving one or maybe even two of our largest financial institutions simultaneously in OLA, an entire insolvent system is another matter. Indeed, this is what Japan faced in the “lost decade.”
Capital injections may become necessary when other measures, including central bank lending or government guarantees are no longer effective. If a large number of financial institutions are in trouble because significant losses have consumed their equity base, additional lending to the institutions may not help. To remain viable, the institutions may have to be recapitalized. As one commentator put it, no matter how much a central bank lends to entities with negative capital, “the capital is still negative.”3
Bailouts through use of public funds are only necessary when efforts to raise private capital do not succeed. Private capital, however, may be insufficient and may therefore make public investments necessary. Due to asymmetric information, private investors may refuse to invest in troubled financial institutions; the government may be in a better position to overcome the information asymmetry.4 In addition troubled financial
institutions may not be able to attract new private equity because of the problem of “debt overhang.” If a firm is heavily leveraged and is on the verge of bankruptcy, any increase in firm value due to an equity infusion largely goes to debt holders.5 Government
intervention thus becomes necessary to overcome the debt overhang problem.
In theory, troubled financial institutions could sell their illiquid and troubled assets to generate capital. Diamond and Rajan (2010) ask why new investors, such as vulture
funds, did not step in to purchase those assets at a bargain price during the financial crisis.6 They argue that the possibility of a future fire sale may explain banks’ inability to dispose of toxic assets. Greenwood et al. contend that modest equity injections can
dramatically reduce systemic risk if they are optimized to minimize the aggregate impact of fire sales.7 Yet a recapitalization plan could be quickly rolled out and would have the added benefit of boosting lending activities.
22 Capital Purchase Program and Other TARP Support Programs
We turn now to examining the Capital Purchase Program, the principal form of capital injection used by the United States during the financial crisis. As the earlier part of this book has discussed in detail, the collapse of Lehman Brothers triggered widespread
turmoil in the global financial market beyond the expectations of Chairman Bernanke and Secretary Paulson.8 Just two days after its bankruptcy, the Federal Reserve had to extend an $85 billion emergency credit facility to AIG, even though some might have considered a capital injection by Treasury to be the better response. The market was deeply confused by the government’s seemingly ad hoc bailout decisions. Who will be bailed out? Who will be let go? Following Bear Stearns’s rescue a few months before, it was assumed that others would also be bailed out. When Lehman sent the opposite message, the rescue of AIG just days later was insufficient to stop contagion fueled by the continuing guessing game. The government finally abandoned its ad hoc approach, which had so far relied heavily on the Federal Reserve and the FDIC, and decided to adopt a comprehensive and proactive plan with direct involvement by the Treasury.
After the rescue of AIG on September 16,9 it was highly uncertain that a bailout plan could be quickly approved. Initially, members of Congress were outraged by Secretary Paulson’s original three-page proposal—some called a “term sheet”—for granting Treasury broad authority to purchase $700 billion of toxic assets.10 Even after the proposal was greatly elaborated, it was rejected by the House of Representatives on September 29, 2008, by a vote largely along party lines (with Republicans opposing).11 The S&P500 plummeted 8.5 percent after the failure.12 The Senate voted two days later to pass a
revised bill and the final bill passed the House on October 3 only after many members of Congress reluctantly switched positions.13 It was signed into law by President Bush on October 3.