In the United States, a series of nineteenth-century banking panics led to the creation of the Federal Reserve System.91 According to Laeven and Valencia (2013) the United States experienced major banking crises in 1837, 1839, 1857, 1861, 1873, 1884, 1890, 1893, 1896, and 1907.92 In each case, liquidity crises suffered by New York banks significantly
amplified the initial panic, ultimately leading to a nationwide run on banks.
During these crises the United States did not have a central bank to provide liquidity, so stabilizing the banking system required a private solution. The private solution routinely involved private bank clearinghouses that would act together upon the onset of a crisis and provide the necessary liquidity.93 In each crisis, clearing houses in large cities such as New York and Chicago primarily acted as private lenders of last resort by providing
emergency reserve currency.94 The effectiveness of such actions was varied.95 J. P.
Morgan (the man) also often played this role by pledging personal funds and organizing top bankers to support illiquid but solvent banks.96 However, after the numerous crises and the realization that J. P. Morgan would not always be around to save the financial system, public support intensified for a central bank to regulate the banking sector and act as an official lender of last resort.97 More important, while private institutions had become adept at responding to a crisis, the only way to prevent a panic in the first place was to establish a lender of last resort that is “sufficiently credible such that depositors always believe it can … purchase the assets of the banking system.”98
By 1913, leading bankers and government officials increasingly agreed that a single centralized lender of last resort was needed.99 Congress hence enacted the Federal Reserve Act in 1913, which provided the Federal Reserve with lender-of-last-resort powers.100 However, weakness of the Federal Reserve’s 1913 lender-of-last-resort authorities was exposed during the banking panics of the early 1930s. At that time the Federal Reserve was prohibited from lending to nonmember banks, and was only permitted to accept a few types of collateral—primarily short-term commercial and
agricultural loans, in addition to Treasury securities.101 When these legal constraints were in place, 65 percent of commercial banks representing 25 percent of deposits were
nonmember banks that had “no direct access to the lender of last resort.”102 History
shows that deposits held at nonmember banks were clearly at greater risk than deposits at member banks. For example, between 1930 and 1932, one dollar of deposits held at a
nonmember bank was five times more likely to be affected by a bank’s suspension of
operations than one dollar of deposits held with a member bank.103 In 1932, following the chaos in the early years of the Great Depression, Congress adopted two major expansions of Federal Reserve’s lender-of-last-resort authorities: Sections 10(b) and 13(3) of the Federal Reserve Act.
First, in February, Congress enacted the Glass–Steagall Act of 1932, which amended the
Federal Reserve Act to include Section 10(b).104 Section 10(b) authorized the Federal
Reserve, under “exceptional and exigent circumstances,” to lend to member banks against a much broader set of collateral than was previously permitted.105 Although the provision was initially intended to be temporary, subsequent legislation extended its lifetime
indefinitely and removed the requirement that such lending only take place in
“exceptional and exigent circumstances.”106 The Monetary Control Act of 1980 required all depository institutions to hold reserves and opened discount window lending to any institution holdings reserves, thus extending this lending to nonmember banks.107
The Federal Reserve continues to act as a lender of last resort to banking institutions through the discount window under Section 10(b), which was redesignated 10B in 1991.108 Discount window loans from the Federal Reserve must be “secured to the satisfaction of [the] Federal Reserve bank.”109 Acceptable collateral that can include government and agency securities, ABS, corporate bonds, money market instruments, and residential and commercial real estate loans, among other eligible securities.110 Fed policy (as distinct from the statute) does not permit unsecured discount window lending, so institutions with no acceptable collateral cannot access it.111 However, subject to several limitations, including the consent of five members of the Board of Governors, the Federal Reserve can lend to groups of five or more member banks that do not have sufficient eligible collateral to borrow through 10B.112 In such cases, recipient banks must “deposit with a suitable trustee, representing the entire group, their individual notes made in favor of the group protected by such collateral security as may be agreed upon.”113 Lender-of-last-resort liquidity support obviously does not carry the same level of risk to taxpayers as straight (and obviously unsecured) capital injections. A recent paper by Martin Hellwig, for example, notes that central banks may have loaned to insolvent institutions during the crisis but that central bank support to banks of dubious solvency does not hurt taxpayers since the central bank is not in danger of losing any money (though inflation may occur and loss of reputation may be at stake).114 Even Lehman Brothers’, which owed the Federal Reserve $46 billion on the date of its bankruptcy, paid back its Fed loans only three days later.115 The lender of last resort does not generally loan to insolvent banks, banks that have lost money due to ineptitude, but there is nothing in Section 10B that prevents it from doing so. The power is designed to protect banks and the financial system as a whole from being victimized by destabilizing contagious panics.
Second, in July 1932, “tucked away in a road construction measure” called the
Emergency Relief and Construction Act, Congress amended the Federal Reserve Act to include Section 13(3).116 Section 13(3) allowed the Federal Reserve, “in unusual and exigent circumstances [and after an] affirmative vote of not less than five members,” to lend to “any individual, partnership, or corporation”117 Prior to 2008, the Fed made few loans under Section 13(3), with most coming between 1932 and 1936 to 123 institutions for an aggregate amount of $1.5 million.118
As initially enacted, Section 13(3) lending was required to be “secured to the satisfaction of the Federal Reserve bank”119 by collateral “eligible for discount for member banks
under” Section 10B.120 This collateral requirement effectively limited the Fed’s ability to lend to nonbank financial institutions, including investment banks, that primarily held investment securities that were not eligible as collateral.121
Less than two weeks before signing 13(3) into law, President Hoover had vetoed a similar provision that would have enabled the Reconstruction Finance Corporation to lend to individuals.122 He expressed concern that granting these authorities “would place the Government in private business in such fashion as to violate the very principle[s] … upon which we have builded our nation.”123 Although there is scant legislative history to support the hypothesis, it is plausible that the onerous collateral requirement was a legislative bargain that enabled the provision to escape veto.
The 1987 financial crisis, however, led to an amendment of Section 13 that increased the discretion of the Federal Reserve to lend to nonbanks by removing the heightened
collateral requirement. In 1991 the FDIC Improvement Act amended Section 13 of the Federal Reserve Act by striking “of the kinds and maturities made eligible for discount for member banks under other provisions of this Act.”124 This opened the door for all notes, drafts, and bills of exchange to be eligible as collateral and left the adequacy of the
collateral to the “satisfaction” of the Fed.125 Senator Christopher J. Dodd (of the Dodd–
Frank Act) ironically authored the 1991 legislation that expanded the LOLR powers of the Federal Reserve, arguing that the expanded powers gave the Federal Reserve “greater flexibility to respond in instances in which the overall financial system threatens to collapse.”126
In short, before Dodd–Frank, the main predicates of emergency §13(3) lending were a five-of-seven vote by the Federal Reserve Board members coupled with the inability of the recipient institution “to secure adequate credit accommodations from other banking institutions.”127 Funds were required to be “secured to the satisfaction of the Federal Reserve,”128 leaving the appraisal of the adequacy of collateral posted by recipients to the Board’s discretion. Under these circumstances the Federal Reserve was authorized to act as the lender of last resort to individual nonbanks including “[i]ndividuals,
[p]artnerships, and [c]orporations” in “unusual and exigent circumstances” by §13(3) of the Federal Reserve Act.129 Combined with the discount window, §13(3) enabled central bank liquidity to reach potentially the entire bank and nonbank financial system (to the extent that borrowers could post collateral that the Federal Reserve deemed to be
adequate).
As already noted, during the financial crisis of 2007 to 2009 the Federal Reserve exercised its §13(3) liquidity power through the creation of a sweeping series of novel borrowing facilities, several of which were intended to benefit nonbanks. Section 13(3) also formed the statutory basis for the Federal Reserve assistance of selected individual nonbank financial institutions, including Bear Stearns and AIG.130
The Federal Reserve also acts as international lender of last resort through swap lines under authority codified in the 1980 amendments to the Federal Reserve Act, specifically Section 14(a) and 14(c).131 Through the swap lines, the Federal Reserve lends US dollars to foreign central banks, which may then be lent to foreign or US institutions. While the
use of swap lines was useful during the financial crisis and the subsequent crisis in the eurozone, a potential critique of swap lines is that they could be used as a “backdoor” use of the Fed’s authority to lend to nonbank financial institutions, thus circumventing the limits on such lending established by Section 13(3). However, the Fed’s authority to grant swap lines rests on authority separate from 13(3) and is thus not restricted by 13(3).
Fortunately, Dodd–Frank prudently did not limit the Federal Reserve’s authority to use swap lines. Restrictions would pose major concerns for foreign central banks having dollar liabilities of their own banks.
Notes
1. Speech by Mario Draghi, president of the European Central Bank (ECB), at the Global Investment Conference in London (Jul. 26, 2012), available at
http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html.
2. Walter Bagehot, Lombard Street: A Description of the Money Market, E. Johnstone, Hartley Withers, eds. (Henry S. King, London, 1873).
3. Sir Francis Baring, Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country 1, 22 (1797).
4. Walter Bagehot, Lombard Street: A Description of the Money Market 1 (1873).
5. See id. at 64.
6. Paul Tucker, The repertoire of official sector interventions in the financial system: Last resort lending, market-making, and capital, Speech at the Bank of Japan 2009
International Conference 1, 5 (May 28, 2009).
7. Walter Bagehot, Lombard Street: A Description of the Money Market 1, 25 (1873).
8. See Thomas Humphrey, Lender of last resort: The concept in history, Fed. Res. Bank of Richmond Econ. Rev. 8, 12–16 (Mar./Apr. 1989).
9. Michael Bordo, The lender of last resort: Alternative views and historical experience, Fed. Res. Bank of Richmond Econ. Rev. 18, 24 (Jan./Feb. 1990).
10. Id. at 27.
11. Marvin Goodfriend and Robert King, The incredible Volcker disinflation. 36 J. Mon.
Econ. 1 (2007).
12. Id.
13. John Holdsworth, The First and Second Banks of the United States 1, 126 (Government Printing Office, Washington, DC, 1902).
14. Id. at 109.
15. Davis Dewey, The Second United States Bank, Washington, DC: National Monetary Commission 1, 154 (1911).
16. Id. at 156.
17. See id. at 163.
18. David Cowen, The First Bank of the United States and the securities market crash of 1792, 60 J. Econ. Hist. 1041, 1042 (2000).
19. Id.
20. Louis Johnston and Samuel Williamson, What was the U.S. GDP then? Measuring worth (2015), available at http://www.measuringworth.com/usgdp/.
21. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1, 6 (1993).
22. John Holdsworth, The First and Second Banks of the United States 1 (1902).
23. John Holdsworth, The First and Second Banks of the United States 1, 132 (1902); see also Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 23 (1902).
24. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 431 (1902).
25. Id..
26. Fred Gotthiel, Principles of Macroeconomics, South-Western College Pub 1, 278 (7th Ed. 2013).
27. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 431 (1902).
28. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1, 19 (1993).
29. Id..
30. Edward Green, Economic perspective on the political history of the Second Bank of the United States, Fed. Res. Bank of Chicago 59, 63 (2003).
31. Id.
32. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1, 38 (1993).
33. Id. at 10.
34. Id. at 38.
35. Id.
36. Richard Painter, Ethics and corruption in business and government: Lessons from the South Sea Bubble and Bank of the United States, University of Chicago Fulton Lectures 1, 17 (2006).
37. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1 (1993).
38. Id.
39. James Wettereau, New light on the First Bank of the United States, 61.3 Penn. Mag.
Hist. Bio. 263, 270 (1937).
40. Id. at 282.
41. Id.
42. See US Congress, House Committee to Investigate the Bank of the United States 279 (1832).
43. H. Wayne Morgan, The origins and establishment of the First Bank of the United States, 30 Bus. Hist. Rev. 472, 474 (1956).
44. Greg Gilner, Global macro trading: Profiting in a new world economy, Bloomberg 1, 9 (2014).
45. John Holdsworth, The First and Second Banks of the United States 1, 197 (1902).
46. Philadelphia Federal Reserve, The First Bank of the United States: A chapter in the history of central banking 1 (Jun. 2009), available at
http://philadelphiafed.org/publications/economic-education/first-bank.pdf.
47. Fritz Redlich, The Molding of American Banking: Men and Ideas, in Two Parts, Johnson Reprint Corporation 1, 10 (New York, 1968).
48. Raymond Walters Jr., The origins of the Second Bank of the United States, 53 J. Polit.
Econ. 115, 122 (1945).
49. Id.
50. Id. at 128.
51. Id. at 129.
52. US Congress, 22d. Cong., 1st sess., Reports of Committees, House Report No. 460 341
(1832).
53. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 451 (1902).
54. Id.
55. Philadelphia Federal Reserve Bank, The Second Bank of the United States: A chapter in the history of central banking 1, 8 (Dec. 2010), available at
https://www.philadelphiafed.org/publications/economic-education/second-bank.pdf.
56. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 84 (1902).
57. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1, 25 (1993).
58. Philadelphia Federal Reserve Bank, The Second Bank of the United States: A chapter in the history of central banking 1, 8 (Dec. 2010), available at
https://www.philadelphiafed.org/publications/economic-education/second-bank.pdf.
59. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 70 (1902).
60. Philadelphia Federal Reserve Bank, The Second Bank of the United States: A chapter in the history of central banking 1 (Dec. 2010), available at
https://www.philadelphiafed.org/publications/economic-education/second-bank.pdf.
61. Jay Shambaugh, An experiment with multiple currencies: The American monetary system from 1838 to 60 (2005) (manuscript on file with Dartmouth College) 1, 12, available at http://www.dartmouth.edu/~jshambau/Papers/AntebellumExchRtsJCS-5- 2005.pdf.
62. Id.
63. Davis Dewey, The Second United States Bank, Washington, DC, National Monetary Commission 1, 193 (1911).
64. Id.
65. Jane Knoddell, Profit and duty in the Second Bank of the United States Exchange Operations, 10 Fin. Hist. Rev. 5 (2003).
66. Bray Hammond, Jackson, Biddle, and the Bank of the United States, 7 J. Econ. Hist. 1, 3 (1947).
67. Id.
68. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and
Institutional History, University of Chicago Press 1, 38–39 (1993).
69. Id.
70. Letter from William H. Crawford to William Jones (Jun. 30, 1818).
71. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 148 (1902).
72. Id. at 150.
73. J. Laurence Broz, The origins of central banking: Solutions to the free-rider problem, 52.2 Int’l Organ. 231, 258 (Spring 1998).
74. Id.
75. Ralph Catterall, The Second Bank of the United States, University of Chicago Press 1, 249 (1902).
76. Id. at 250.
77. Id.
78. See, for example, Osborne v. Bank of the United States, 22 US 738 (1824); McCulloch v. Maryland, 17 US 316 (1819).
79. Bray Hammond, Jackson, Biddle, and the Bank of the United States, 7 J. Econ. Hist. 1, 5 (1947).
80. Id.
81. Timberlake, supra note 596 at 39.
82. Curzio Giannini, “Enemy of none but a common friend of all”? An international perspective on the lender-of-last-resort function, 214 Essays Int’l Fin. 24 (1999).
83. Richard Timberlake Jr., Monetary Policy in the United States: An Intellectual and Institutional History, University of Chicago Press 1, 39 (1993).
84. Id.
85. Miller Center, University of Virginia, Domestic affairs: Rotation in office and the spoils system, American President: A Reference Resource, available at:
http://millercenter.org/president/jackson/essays/biography/4 86. Id.
87. Davis Dewey, The Second United States Bank, Washington, DC, National Monetary Commission 1, 299 (1911).
88. Id. at 299, 305.
89. H. W. Brands, Andrew Jackson: His Life and Times, Anchor 1, 486 (Oct. 10, 2006).
90. Asaf Bernstein, Eric Hughson, and Marc D. Weidenmier, Central banking and funding liquidity 1, available at
http://www.usc.edu/schools/business/FBE/seminars/papers/M_WEIDERMEYER_v9- 16-2010.pdf.
91. Id. at 23.
92. Fabian Valencia and Luc Laevan, Systemic banking crises database, IMF Econ. Rev.
61(2), 225–270 (2013). Charles Calomiris and Luc Laeven, Political foundations of the lender of last resort: A global historical narrative (Dec. 19, 2014).
93. See Gary Gorton and Andrew Metrick, The Federal Reserve and financial regulation:
The first hundred years 1, 8 (NBER Working Paper No. 19292, 2013).
94. Id. at 23.
95. Id. at 23.
96. See Panic of 1907, Fed. Res. Bank of Boston (1990), available at http://www.bostonfed.org/about/pubs/panicof1.pdf.
97. Id. at 11. (“Senator Nelson Aldrich of Rhode Island summed up the general feeling.
‘Something has got to be done,’ he declared; ‘We may not always have Pierpont Morgan with us to meet a banking crisis.’”).
98. Id.
99. See Mark Carlson and David Wheelock, The lender of last resort: Lessons from the Fed’s first 100 years (Fed. Reserve Bank of St. Louis, Working Paper 2012–056B, 2013), available at http://research.stlouisfed.org/wp/2012/2012-056.pdf.
100. Id. at 3.
101. Id. at 11.
102. Id. at 7.
103. Id. at 7.
104. Howard Hackley, Lending functions of Federal Reserve banks: A history 1, 124 (1973), available at
https://fraser.stlouisfed.org/docs/publications/books/lendfunct_hackley1973o.pdf.
105. Id. at 101.
106. As originally enacted, the provision would have expired in March 1933. However, the Emergency Banking Act of 1933 lengthened its duration and authorized the Federal
Reserve to make equivalent loans to nonmember banks. According to one Senator instrumental in extending the authority to nonmember banks, the expanded powers sought “to place the State banks nearer on a parity with member banks.” While the expanded authority to lend to non-member banks expired in 1934, the Banking Act of August 1935 extended its other provisions indefinitely and permitted lending during ordinary periods. Howard Hackley, Lending functions of Federal Reserve banks: A history 1, 124–125 (1973), available at
https://fraser.stlouisfed.org/docs/publications/books/lendfunct_hackley1973o.pdf;
Mark Carlson and David Wheelock, The lender of last resort: Lessons from the Fed’s first 100 years 1 (Fed. Res. Bank of St. Louis, Working Paper 2012–056B, 2013), available at http://research.stlouisfed.org/wp/2012/2012-056.pdf.
107. Kenneth J. Robinson, Depository Institutions Deregulation and Monetary Control Act of 1980, Federal Reserve Bank of Dallas (March 1980), available at:
http://www.federalreservehistory.org/Events/DetailView/43.
108. See Bd. of Governors of the Fed Res. Sys., The Federal Reserve Discount Window (2015); see also 12 USC 347b(a); see also Bd. of Governors of the Fed Res. Sys., Advances to Individual Member Banks (2015) .
109. 12 USC 347b(a).
110. Id.
111. Section 10B requires that loans are “secured to the satisfaction of [the] Federal Reserve Bank. 12 USC 347b(a). For a summary of Federal Reserve lending programs and collateral accepted, see, for example, Fed. Res. Bank of New York, Forms of Federal Reserve lending (2015), available at
http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf.
112. Federal Reserve Act Section 10A. 12 USC §347a.
113. 12 USC §347a.
114. See Martin Hellwig, Financial Stability and Monetary Policy, MPI Collective Goods Preprint, No. 2015/10, 12-13 (August 2015), available at:
http://ssrn.com/abstract=2639532.
115. Sourced from Bloomberg.
116. Howard Hackley, Lending functions of Federal Reserve banks: A history 1, 128 (1973), available at
https://fraser.stlouisfed.org/docs/publications/books/lendfunct_hackley1973o.pdf;
Mark Carlson and David Wheelock, The lender of last resort: Lessons from the Fed’s first 100 years 1, 11–12 (Fed. Res. Bank of St. Louis, Working Paper 2012–056B, 2013), available at http://research.stlouisfed.org/wp/2012/2012-056.pdf.