Federal Reserve: Lender of Last Resort Functions

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he Federal Reserve (Fed), the nation’s central bank, was established in 1913 by the Federal
Reserve Act (38 Stat. 251). Today, its primary duty is the execution of monetary policy
through open market operations. Open market operations are carried out through the T

purchase and sale of U.S. Treasury securities in the secondary market in order to alter the reserves
of the banking system. By altering bank reserves, the Fed can influence short-term interest rates,
and hence credit conditions, to fulfill its mandate to promote stable economic growth and low and ¹
stable price inflation. Besides the conduct of monetary policy, the Federal Reserve has a number
of other duties: it regulates financial institutions, issues paper currency, clears checks, collects ²
economic data, and carries out economic research. This report focuses on one particular
responsibility: to act as a lender of last resort to the financial system to prevent financial panics.
As explained below, the Fed can carry out its lender of last resort duties directly, by making
discount loans to member banks, or indirectly, through open market operations.

Financial institutions are susceptible to two types of financial problems. First, an institution can
become insolvent if its liabilities exceed its assets. For financial institutions, this is likely to be
caused by a decline in asset values. For example, when borrowers default on loans, the loans—
which are assets to the bank—lose their value, while the value of the deposits the bank used to
finance these loans remain the same. Second, an institution can become illiquid if creditors ³
withdraw their funds more quickly than the institution can liquidate its assets to pay them. Banks
are particularly prone to this problem because of the maturity mismatch between assets (long-
term loans) and liabilities (short-term deposits). For example, depositors can withdraw funds from
their checking accounts instantaneously, but selling an illiquid asset (such as a loan) at other than
distressed prices takes time. For that reason, banks hold liquid reserves to account for typical
fluctuations in account withdrawals. But if withdrawals are large enough to exceed reserves, a
liquidity crisis will ensue.
From its founding, the role of lender of last resort has been central to the Fed’s mission. ^th
Recurring financial panics of the 19 century and in 1907 showed major structural weakness in
the U.S. financial system, providing political impetus to create a central bank. Ironically, the Fed
did little to prevent the nation’s greatest financial panic, 1930-1933, when more than 9,000 banks
failed as a result of a liquidity crisis. In the absence of deposit insurance, depositors knew that
they could lose some or all of their deposits if they did not remove their funds before a bank
failed. Because of insufficient information about a bank’s finances, depositors could only guess if
their bank was solvent or insolvent. Thus, bank failures in many cases became a self-fulfilling
prophecy. If enough depositors suspected a bank was insolvent—even if it was healthy—a bank
run would begin. Because its assets were illiquid, even a healthy bank would be unable to satisfy
all withdrawals. At this point, the bank would be forced to close.

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There are two ways the government can prevent or mitigate bank panics. The first is to take away
the motivation for bank runs (the depositor’s fear of losing his savings) through deposit ⁴
insurance. A classic bank run has not occurred since the establishment of deposit insurance in
1934. The second way is to offer banks a way to swap illiquid assets for liquid assets. The Fed
carries out this function through the operation of the discount window. But the 1930-1933
banking crisis suggests that a discount window (that requires high-quality collateral) is not
enough to avert a bank panic.
Financial panics can be more generalized than a few institutions, and not necessarily limited to
the banking system. The Fed can use open market operations to increase the liquidity of the entire
financial system—although this option cannot be targeted to specific institutions in trouble. In
this case, the Fed is not acting as a lender of last resort for any particular institution, rather it is
acting more broadly to maintain the smooth functioning of the overall financial system.
The discount window is the mechanism through which banks borrow directly from the Federal
Reserve. The Fed limits discount window lending to banks with liquidity problems—it frowns ⁵
upon banks using the discount window as a regular source of financing. Short-term loans are
called primary credit and longer-term loans are called secondary credit. All loans must be secured
with acceptable collateral, such as U.S. Treasury securities. To prevent the Fed from propping up
insolvent banks with discount window lending, undercapitalized banks can typically borrow from
the discount window for a maximum of only 60 days during any 120-day period. Discount
window lending to non-bank firms is legally possible in special circumstances, but has not
occurred since the 1930s.
Discount window lending has the same effect on the economy as expansionary open market
operations—by increasing the reserves of the banking system, all else equal, it reduces interest
rates and provides a short-term boost to aggregate spending. Nevertheless, open market
operations dwarf discount window lending. Discount window loans typically average tens of ⁶
millions of dollars per week. By comparison, gross open market operations average in the
hundreds of billions. Since the mid-1980s, primary credit (previously called adjustment credit)
has been below $0.5 billion per year, and below $0.2 billion since the early 1990s. In recent ⁷
years, about 25 banks a week borrowed from the discount window.
In normal financial conditions, banks can manage fluctuations in their reserves by borrowing or
lending reserves in the federal funds market. (The interest rate in this private market, the federal
funds rate, is the Fed’s target for monetary policy.) Banks are discouraged from turning to the
discount window in normal conditions because the discount rate, set by the Fed, is higher than the
federal funds target rate. Until 2003, the discount rate had been set below the federal funds target

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rate and discount window borrowing under normal conditions had been discouraged by the Fed
through moral suasion.
There is a special case where discount window lending may need to be extended to financial
institutions that are essentially insolvent, rather than illiquid. This is the case of too-big-to-fail
banks, or banks whose closure would disrupt the smooth operation of the financial system as a
whole. There is no objective way to identify when an institution becomes too big to fail. It can be
argued that government regulators have purposely remained ambiguous in their own definition,
perhaps in the belief that ambiguity would discourage any firm from acting recklessly because it
knew it would be “bailed out” if it failed (the “moral hazard” problem). The most famous
example of the “too big to fail” doctrine was the 1984 resolution of the Continental Illinois crisis,
which was the nation’s seventh largest bank by assets at the time of its crisis. Continuing access
to the discount window was one component of the government’s resolution plan—a plan most ⁸
remembered for the government’s decision to fully compensate uninsured depositors.
At times, critics have called for discount window lending to be abolished. Although liquidity
problems are legitimate, the federal funds market offers banks a market solution to liquidity
problems. If a bank cannot convince the private sector to help it overcome liquidity problems, one
can argue that discount window lending represents a subsidy from the federal government to a
bank that the market has deemed should fail. (The counter-argument is that banks may be unable
to tell if a troubled bank is illiquid or insolvent and refuse to lend to it, making the discount
window necessary.) This potential for subsidy is a cost that must be weighed against the benefit of
a more stable banking system that the discount window arguably provides.
At times, the threat to financial stability is not limited to a few institutions, but is spread
throughout the financial system. In these instances, expansionary open market operations is the
favored method for restoring calm. Open market operations allow the Fed to inject essentially
unlimited liquidity into the financial system as a whole, which offsets the private money flowing
out of the financial system. Calm is then restored as sellers of financial instruments can again find
buyers, and vice versa. This scenario is different from normal open market operations because, in
the absence of financial unrest, the injection of liquidity would be incompatible with the Fed’s
mandate to provide price stability.
Unlike discount window lending, open market operations allow the Fed to respond to financial ⁹
crises in the non-banking financial sector. A limitation of this approach, however, is that the
generalized nature of open market operations can be too blunt a tool to neutralize more localized
market problems. Theoretically, the Fed could intervene directly in the troubled market (although
in some instances this would require statutory changes), but the Fed declines to do so because
many would view this as “picking winners.” By contrast, judicious use of the discount window is
more politically acceptable when a banking crisis is localized, although in a sense, this could be
seen as “picking winners” as well. However, the banking system is particularly susceptible to

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liquidity problems and plays a very special role in the monetary transmission mechanism that
makes it unique.
Lender of last functions cannot easily be distinguished from normal monetary operations
executed in the pursuit of stable economic conditions. It can be difficult to identify specific
instances when a lender of last resort has been successful, since a successful lender of last resort
is one that does not allow financial crises to occur. Because the United States has not suffered a
serious financial panic since the Great Depression, the United States has either enjoyed a very
long streak of good luck or the lender of last resort has done a very fine job indeed. While
identifying such events is admittedly ambiguous, recent history nevertheless offers a few good
examples of occasions when financial crises would have been possible, had it not been for the
actions of the Federal Reserve.
The most recent and dramatic event in which the Fed acted as a lender of last resort was in the
aftermath of the September 11 attacks. To forestall any possibility of a financial panic or a break-
down in banking activity, the Federal Reserve immediately issued a simple 17 word statement:
“The Federal Reserve System is open and operating. The discount window is available to meet
liquidity needs.” This immediately reassured the financial system that ample liquidity would be
available on request, without reprimand. To supplement the liquidity sought by banks through the
discount window, the Federal Reserve bought a large number of government securities through
open market operations. On the three days after the attack, the Federal Reserve injected over $100
billion per day into the financial system through discount window lending and open market ¹⁰
operations. In addition, the Federal Reserve entered into or expanded existing agreements with
the European Central Bank, the Bank of Canada, and the Bank of England to swap dollars for
foreign currency in order to support foreign financial institutions operating in the United States.
On September 17, the day the New York Stock Exchange re-opened, the Federal Reserve lowered
the key federal funds rates by 0.5 percentage points. In the next three months, it made three
additional rate cuts, bringing the federal funds target to 1.75% on December 11, 2001.
Some other examples of episodes in which the lender of last resort role was important were the ¹¹
Y2K episode, September 1998, and the stock market crash of October 1987. In all three of these
examples, economic growth was strong at the time of the intervention, so the expansion of
liquidity would not have been justified on usual grounds. In all three cases, the lender of last
resort function was carried out primarily through open market operations; discount window
lending did not play an important role in any case. While overall discount window lending rose
slightly in 1987 and 1999-2000, the increase was not significant; in the fall of 1998, discount
window lending fell. The reliance on open market operations may be due to the fact that these
episodes did not directly involved the banking sector, with the possible exception of theY2K
episode. In that case, the Fed set up a “Century Date Change Special Liquidity Facility” through
the discount window from October 1999-April 2000, but it was never widely used. At its peak,

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borrowing from the facility reached a daily average of $124 million during the two-week period ¹²
ending December 29.

Lender of last resort functions are an invaluable duty of the Federal Reserve, and one that cannot
realistically be executed by any other governmental body since the Fed controls the money
supply. While few would argue with the general necessity of a lender of last resort, some would
question whether providing lender of last resort functions was appropriate in specific cases. The
Fed has been vague and ambiguous about the criteria that guide its decision making in lender of
last resort situations, seemingly deciding on an ad hoc basis. Ambiguity may be necessary to
prevent moral hazard on the part of the financial sector (e.g., if banks were explicitly designated
as “too big to fail”), but it makes objective evaluation by outsiders difficult. It is difficult to say
whether the economy would have been better off if the Fed had not acted, since one cannot tell
what “might have been” in the counter-example. For example, if the financial system could have
rebounded on its own in September 1998, the Fed’s intervention may have further inflated the
stock market bubble, causing additional damage to the economy when it eventually burst in 2001.
Since the economic costs of withholding lender of last resort functions exceed the costs of over-
providing, it is arguably appropriate to err on the side of caution, as the Fed seems to do.
^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
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