The Fed's Emergency Lending Evolves

"It took years for the Fed to develop the tools during the 2007-2009 crisis necessary to ensure the adequate provision of liquidity and to manage threats to the financial system," says Kim Schoenholtz of New York University's Stern School of Business. "What's remarkable this time around is how, almost instantaneously, the Fed not only revived all of the critical liquidity tools that were developed in the previous crisis, but also added to them."

For each of these programs, the Fed invoked section 13(3) of the Federal Reserve Act, which authorizes the Fed to lend to a broader set of recipients during a crisis — or as Congress put it, in "unusual and exigent circumstances." Few would argue that the pandemic does not qualify as unusual, but deciding when and to whom the Fed should lend has been a debate among policymakers and economists that stretches back to the Fed's founding.

Lender of Last Resort … for Whom?

The Fed was originally created to solve a problem of liquidity in the banking system. Seasonal demands for cash placed a strain on banks, leading to periodic banking panics. (See "Liquidity Requirements and the Lender of Last Resort," Econ Focus, Fourth Quarter 2015.)

The framers of the Federal Reserve Act sought to solve this problem by creating a system of regional Reserve Banks that could purchase short-term commercial loans from banks when demand for cash spiked. Member banks could get cash from their Reserve Bank by exchanging commercial paper for it at the discount window. (Originally, each Reserve Bank had a physical window where member banks came for these exchanges; today, discount window transactions are handled electronically.) While the Fed was empowered to make loans to banks, businesses and individuals couldn't walk into their local Reserve Bank and ask for a loan — the Fed was envisioned as a "banker's bank."

That began to change during the Great Depression. As banks failed throughout the country, the normal market for commercial credit collapsed. Legislators and President Herbert Hoover worried that it was not enough for the Fed to support banks if those banks were reluctant or unable to make loans for productive ventures. In 1932, Congress made the change to the Federal Reserve Act that authorized broader lending in "unusual and exigent circumstances." The new section 13(3) authorized Reserve Banks to lend directly to individuals and corporations in emergencies.

This new power put the Fed in the business of making commercial loans, but it used that authority sparingly. Reserve Banks made just 123 loans totaling $1.5 million between 1932 and 1936 (around $28 million in today's dollars). In a 2010 article in the University of Pennsylvania's Journal of Business Law, Alexander Mehra, a lawyer, argued that this was likely due to several restrictions contained in the original text of section 13(3). First, Reserve Banks were only authorized to lend to individuals and businesses against the same type of collateral that they accepted for lending to banks — short-term loans originating from commercial activity. Businesses, individuals, and investment banks were unlikely to have this type of collateral, making them ineligible for loans from the Fed.

Second, each loan required the approval of five of the Fed's governors, a difficult procedural hurdle to clear. Finally, Congress had also created the Reconstruction Finance Corporation (RFC) in 1932. The RFC was a government-sponsored enterprise also tasked with making loans to individuals and businesses. Those loans were generally available at more favorable terms than loans from the Fed, which may further explain why the Fed had few takers.

Another reason section 13(3) saw little use was that it was soon superseded by a further amendment to the Federal Reserve Act in 1934 — the addition of section 13(b). That amendment placed fewer restrictions on the Fed's ability to lend to businesses and saw much wider use. In the first year and a half, the Fed made nearly 2,000 section 13(b) loans totaling $124.5 million ($2.3 billion today).

The Fed's Board of Governors was initially supportive of these new lending powers, stating in a 1934 press release that they would "aid in the recovery of business, the increase of employment, and the general betterment of conditions throughout the country." But as with section 13(3), the Fed's section 13(b) lending would also be overshadowed by the RFC. The RFC continued to be the industrial lending agency of choice, and, aside from a brief resurgence during World War II, the volume of the Fed's section 13(b) loans dropped significantly after 1935.

In the postwar period, Fed leaders began to question whether the central bank should be involved in making loans to businesses and individuals. In 1957, then-Fed Chair William McChesney Martin told Congress during testimony that while there might be a role for the government to address gaps in private sector lending, it was not one that the Fed should play. Rather, he said it was the preference of the Board of Governors for the Fed to "devote itself primarily to the objectives set for it by the Congress, namely, guiding monetary and credit policy so as to exert its influence toward maintaining the value of the dollar and fostering orderly economic progress."

It took decades after the Fed's founding, but eventually economists and political leaders came to see the benefits to the economy of the Fed having monetary policy independence.

"The question is whether it is appropriate to burden a central bank that has the mandate of achieving price stability and maximum sustainable employment with also managing the supply of credit directly to nonfinancial organizations, such as businesses, corporations, or municipalities," says Schoenholtz. "Those credit allocation decisions are politically fraught. Back in the 1930s, I don't think anybody really understood the long-run benefits of having an independent central bank."

Congress ultimately agreed to remove those credit allocation powers from the Fed. The Small Business Investment Company Act of 1958 struck section 13(b) from the Federal Reserve Act and transferred those powers to the Small Business Administration (SBA). But section 13(3), the original emergency lending authority granted to the Fed, remained on the books.

While the Fed has announced a wider range of emergency lending programs than in 2007-2009, the total dollar amount of loans has been smaller so far. As of mid-August, the Fed had about $96 billion in outstanding section 13(3) loans. (See chart.) In fact, the Fed began to wind down some of the first programs launched in March as financial markets stabilized from the initial disruptions of the pandemic.

The Fed's emergency lending during the pandemic has been shaped by the changes made to section 13(3) by Dodd-Frank. All the lending facilities have broad-based eligibility rather than being open only to a specific firm or a small set of firms. The Fed obtained permission from the secretary of the Treasury before creating each facility, and the Treasury has provided a backstop against losses for any facilities that are not inherently risk free. Those Treasury funds were appropriated through the Coronavirus Aid, Relief, and Economic Security, or CARES, Act.

There is some precedent for the Fed providing liquidity support during a pandemic. During the Spanish Flu outbreak of 1918, banks faced liquidity strains. A recent paper by Haelim Anderson of the Federal Deposit Insurance Corporation, Jin-Wook Chang of the Federal Reserve Board, and Adam Copeland of the New York Fed found that banks that were members of the Federal Reserve System were able to continue or even expand lending during the pandemic because of their access to central bank liquidity, while nonmember banks curtailed lending. The researchers argued that this highlights the importance of the Fed having the flexibility to act as a lender of last resort to financial firms outside of the traditional banking sector.

But such flexibility may come at a price. "If markets know the Fed can be relied upon as a liquidity backstop, the Fed can nip market disruption in the bud," says Alex Wolman, vice president for monetary and macroeconomic research at the Richmond Fed. "We saw that play out during the current crisis — initial market volatility in March subsided after the Fed took action. On the other hand, an expectation that the Fed will act as a backstop may distort market prices and encourage excessive leverage in the long run. It can be challenging for a central bank to balance these considerations."

Indeed, some Fed scholars have argued that the newly created programs designed to lend to businesses and governments step beyond the boundaries Dodd-Frank established around emergency lending. In a May working paper, Lev Menand of Columbia Law School argued that the new facilities created to extend credit to businesses and municipalities sidestep the Dodd-Frank requirement that section 13(3) lending should be for the purpose of "providing liquidity to the financial system"since the recipients are not financial firms. Instead of amending the Federal Reserve Act to loosen restrictions on Fed emergency lending, when Congress appropriated the funds for these facilities in the CARES Act, it simply stated that they were for the purpose of providing liquidity to the financial system.

"If lending directly to business is a way to provide liquidity to the financial system, then any lending meets the requirement and the words added [to the Federal Reserve Act] in 2010 have no meaning," Menand wrote.

After largely walking away from lending to nonfinancial firms for decades, the Fed has found itself acting as a lender of last resort for more than just banks during two crises in the span of a dozen years. This has sparked renewed discussion among economists and policymakers over just what it means to be a lender of last resort.