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)