Note they’ve also added the international arrangements as per my discussion earlier today.

The same recommendations suggested in August.

7 Lending by the Federal Reserve

The Federal Reserve’s authority to extend loans is a potentially powerful tool with

which it can stimulate aggregate demand. Loans to depository institutions can help spur credit extensions to households and firms. If depository institutions are unwilling or unable to lend to firms and households, direct loans by the Federal Reserve to firms and households could provide the financing needed for economic recovery- although such lending is subject to the restrictions discussed below.

The above has the causation backwards. In the banking system, loans ‘create’ deposits, which many incur reserve requirements.

In the first instance, new reserve requirements are functionally an ‘overdraft’ in the bank’s reserve account at the fed. Since an overdraft *is* a loan, as a matter of accounting loans create both deposits and any resulting new required reserves. What the fed does is set the price of the reserves (the rate of interest), which influences bank lending decisions, but doesn’t directly control bank lending.

Therefore, all fed lending to member banks is generally to replace ‘overdrafts’ in reserve accounts. At the end of each statement period, overdrafts are booked as loans from the fed’s discount window, which are 50 bp over the fed fund rate and also carry a ‘stigma’ of implying the bank is having financial difficulties. That’s why banks are willing to bid up funds above the discount rate when trading each other,

7.1 Lending to Depository Institutions

As shown in table 7.1, lending to depositories is authorized under several sections of the Federal Reserve Act: Advances are authorized under sections 10B, 13(8) and 13(13), while discounts are authorized under sections 13(2), 13(3), 13(4), 13(6) and13A.78 In recent decades, the Federal Reserve has extended credit to depositories only through advances (under sections 10B and 13(8)) and has not made any discounts. The broadest and most flexible authority under which the Federal Reserve can extend loans to depositories is Section 10B, under which the restriction on collateral is only that the Reserve Bank making the advance deems the collateral to be “satisfactory”.

Yes, and this makes perfect sense. All bank collateral is limited to what the federal regulators deem ‘legal’ along with regulated concentration and gap limits. Also, banks can issue federally guaranteed liabilities; so, functionally the government is already funding what they deem legal assets. So, for the fed to provide another channel for this process, to assist ‘market functioning’, changes nothing of substance regarding risk for the government.

The collateral can be promissory notes, such as corporate bonds and commercial paper- instruments that cannot be purchased by the Federal Reserve.

But, as above, instruments that are categorized as bank legal by federal regulation, and can already be funded via government insured deposits.

Currently, Reserve Banks accept as collateral various types of promissory notes of acceptable quality including state and local government securities, mortgages covering one- to four-family residences, credit-card receivables, other customer notes, commercial mortgages, and business loans. Apparently, even equity shares would be legally acceptable as collateral if a Reserve Bank found them to be acceptable as collateral.

78The differences between discounts and advances are discussed briefly below and in more detail

in Section 2.1 of Small and Clouse (2000).

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Table 7.1

Credit Instruments Used in Discounts or Advances

Borrower Credit Instrument

Depositories

10B Advances* Depository’s time and demand notes secured \to the

satisfaction of [the] Reserve Bank.” * *

13(8) Advances Depository’s promissory note secured by U.S Treasury,

U.S.-guaranteed, U.S. agency, or U.S. agency-guaranteed

securities, or by credit instruments eligible for discount or purchase.

13(2) Discounts * * * Notes, drafts and bills of exchange meeting \real bills” criteria.

13(4) Discounts * * * Bills of exchange payable on sight or demand which grow out of the shipment of agricultural goods.

13(6) Discounts * * * Acceptances which grow out of the shipment of goods

(section 13(7)) or for the purpose of furnishing dollar exchange as required by the usages of trade (section 13(12)).

13A Discounts * * * Notes, drafts, and bills of exchange secured by agricultural paper.

IPCs * * * *

13(13) Advances IPC’s promissory notes secured by U.S. Treasury, U.S. Agency or U.S. agency-guaranteed obligations.

13(3) Discounts Notes, drafts, and bills of exchange endorsed or otherwise secured to the satisfaction of the Reserve Bank, in unusual and exigent circumstances”, and provided the IPC cannot secure adequate credit elsewhere or is in a class for which this determination has been made.

Notes: All advances and the financial instruments used as collateral in all discounts except section 13(discounts are subject to maturity limitations. Section 13(14) authorizes discounts and advances to branches and agencies of foreign branches, subject to limitations.

*Section 10A provides for advances to groups of member banks.

* * Advances to undercapitalized and critically undercapitalized institutions are subject to limitations listed in section 10B.

* * * Must be endorsed by a depository institution.

* * * * Depository institutions are corporations and thus qualify for lending authorized for IPCs.

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Even though the Federal Reserve can extend credit to depositories through advances secured by a wide array of instruments, there may be limitations regarding the extent to which the Federal Reserve can take onto its balance sheet the credit risk of a private-sector security pledged as collateral{whether the security is pledged as part of an advance or a discount. With an advance, the loan is extended on the basis of a promissory note issued by the depository. During the course of the advance, should the ability of the depository to repay the advance come under question (for example, because the collateral is in default) the Federal Reserve would look to the depository first for repayment: The credit risk of the collateral therefore remains with the depository.79 In a discount, the depository does not issue its own note to the Federal Reserve, but the depository must endorse the security that is discounted (as indicated by the triple asterisks in table 7.1). Again, the credit risk of the underlying collateral stays with the depository institution, and the only risk the Federal Reserve takes onto its balance sheet is the risk that the depository will default.80

79In a similar vein, the Bank of Japan recently has undertaken repurchase agreements in commercial paper but has acted to protect its balance sheet from the credit risk of the issuer of the commercial paper:

The Bank recommends commercial paper (CP) operations (purchase of CP with resale agreements) in order to ensure smooth market operations.

CP will be purchased from financial institutions, securities companies, and tanshi companies (money market dealers) which hold accounts with the Bank. The CP is to be endorsed by the seller, and to have a maturity of 3 months or less from the day of the Bank’s purchase. Purchase is to be made under competitive bidding, and the period of the purchase is to be 3 months or less. (See Quarterly Bulletin (1996), page 100.)

In September of 1998, the Bank of Japan held, through repurchase agreements, about 35 percent of the outstanding stock of commercial paper in Japan. See Table VII in Economic Statistics Monthly

(See various dates).

80Discounts under sections 13(2), 13(4) or 13A for a bank require a \waiver of demand, notice and protest by such bank as to its own endorsement exclusively”, which is discussed by Hackley (1973)

(pp. 22). The effect of this waiver is to make the endorsing bank primarily liable because the Reserve Bank would not have to demand payment by the issuer of the discounted paper before proceeding against the bank. To further limit its credit-risk exposure, the Federal Reserve presumably would also take a \haircut” on the discount by extending funds that are significantly less than the value of the discounted instrument. Additionally, the Federal Deposit Insurance Corporation Improvement

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To the extent the credit risk of the collateral remains with the depository, lending to depositories may do very little to lower the credit-risk premiums charged by depositories in making new loans to private-sector borrowers. Credit risk premiums could be a major factor holding down credit expansion and economic recovery should nominal rates on Treasury bills be at or near zero and should the economy be weak.

In private-sector markets, credit risk can be managed through the use of credit- risk options. And, in some circumstances, the Federal Reserve’s incidental powers clause is consistent with the Federal Reserve using options.81 However, the view that the Federal Reserve could not accept the credit risk of the collateral used in discount window loans may leave little scope for the Federal Reserve to write credit-risk options in order to take that credit risk of the balance sheets of depositories and onto its balance sheet.

But even if Federal Reserve loans to depositories leave credit-risk premiums unchanged, such loans may provide some liquidity for the financial instruments used as collateral helping to lowering private-sector interest rates by reducing implicit liquidity premiums.

7.2 Lending to Individuals, Partnerships, and Corporations

Although the Federal Reserve currently does not make loans to individuals, partnerships, and corporations (IPCs), the Federal Reserve has the authorization to bypass depositories and make such loans under sections 13(3) and 13(13) of the Federal Reserve Act- as shown in table 7.1. However, lending under these authorities is subject to very stringent criteria in law and regulation, and such lending has not taken place since the Great Depression. For example, advances, under section 13(13), are limited

Act of 1991 (FDICIA), through its \prompt corrective action” provisions has imposed restrictions on depository institutions in weak capital condition. Among those restrictions are limitations on access to the Federal Reserve’s discount window.

81See footnote 46 for a discussion of the Federal Reserve’s recent use of options, and see Section 4 of Small and Clouse (2000) for a discussion of the Federal Reserve’s authority to engage in options.

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to those “secured by direct obligations of the United States or by any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, an agency of the United States.”

Because IPCs with such collateral could easily sell it in the open market, section 13(13) advances may not have much effect(unless done at subsidized rates) in stimulating aggregate demand.

In contrast, private-sector instruments may lack the liquidity of Treasury debt and, therefore, Federal Reserve loans that use them as collateral may provide liquidity and help stimulate the economy. Also, in a \credit crunch”, such direct loans would circumvent depository institutions and the \non-price” terms of credit imposed by them. Hence, we shall focus on section 13(3) discounts of:

“notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are endorsed or otherwise secured to the satisfaction of the Federal Reserve bank: … ”

Because notes, drafts, and bills of exchange include most forms of written credit instruments, section 13(3) provides virtually no restrictions on the form a credit instrument must take in order to be eligible for discount.82 And by merely requiring that the discount be \secured to the satisfaction of the Federal Reserve bank …”, there is no restriction on the use of funds (such as for \real bills” purposes) for which the discounted security was originally issued.

However, in making section 13(3) loans directly to IPCs, the Federal Reserve must impose standards that are much more stringent in comparison to those used in lending to a depository. Such lending to IPCs is authorized only in “unusual and exigent circumstances.” In particular, the statute requires that a loan can be extended only to IPCs for which credit is not available from other banking institutions.83 Activation

82The distinctions between notes, drafts, and bills of exchange are discussed in detail in Small and Clouse (2000).

83The Federal Reserve’s Regulation A (Section 201.3(d): Emergency credit for others) species that advances to IPCs would be contemplated only in situations in which failure to advance credit would adversely affect the economy.

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of this authority requires the affirmative vote of five of the seven governors of the Federal Reserve Board.

Section 13(3) further requires that the collateral be “endorsed or otherwise secured to the satisfaction of the Federal Reserve bank …” As interpreted by Hackley (1973):

… it seems clear that it was the intent of Congress that loans should be made only to credit-worthy borrowers; in other words, the Reserve Bank should be satisfied that a loan made under this authority would be repaid in due course, either by the borrower or by resort to security or the endorsement of a third party.84

If binding, this restriction could seriously curtail the effectiveness of such loans in stimulating aggregate demand in an environment of elevated credit risk and risk aversion.

But even if the Federal Reserve were able to accept private-sector credit risk onto its balance sheet, any social benefits to the Federal Reserve lending directly to the private sector would need to be balanced against the potentially serious drawbacks associated with placing the Federal Reserve squarely in the process allocating credit within the private sector. The information available to the Federal Reserve about nonbank credit would in many cases be inadequate to reliably assess credit risks{ and there is little reason to believe the Federal Reserve could assess credit risks more accurately than do private intermediaries. Problems with adverse-selection could lead to the Federal Reserve lending to precisely those credit risks that it most severely underestimates. After the credit is extended, the Federal Reserve may not be well situated to monitor the ongoing activities of the recipients of the funds to ensure the activities are consistent with the terms of the contract. Some of these problems might be addressed through the Federal Reserve using credit-ratings from private sector firms.

Moreover, such programs could develop important political constituencies that might make the programs difficult to dismantle once the immediate aim of policy|

84Hackley (1973), page 129.

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namely providing a short-run economic stimulus- had been achieved.


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