1. Two Cheers for Bagehot John C. Williams Federal Reserve Bank of San Francisco Reserve Bank of India First International Research Conference 2010 “Challenges to Central Banking in the Context of Financial Crisis” February 12-13, 2010 The views expressed in this paper are solely those of the author and should not be interpreted as reflecting the views of the management of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

2. Bagehot’s Dictum To forestall panics, Bagehot said the central bank should lend freely under three conditions: – Solvent borrowers – Good collateral – High interest rate Principle not limited to banks – Any solvent borrower with illiquid assets and short- term funding needs

3. Bagehot and the Fed In the United States, depository institutions have access to discount window: – Soundness test – Collateral with haircut – Penalty rate over fed funds target In “unusual and exigent circumstances” Fed can lend to other entities. This “13(3)” clause was invoked several times during the crisis. Lending programs exceeded $1.5 trillion in December 2008, has since declined dramatically.

4. Fed Liquidity Programs

5. Limits to Bagehot: Stigma Starting in summer of 2007, “Libor” rates on one-month and longer interbank loans rose. Banks shunned discount window, in part because of stigma associated with such borrowing: – penalty rate – perception that Fed prefers banks use markets for liquidity Term auction facility (TAF) introduced in December 2007 with goal of reducing stigma and increasing willingness to borrow (also, no penalty rate if auction undersubscribed). Swaps with several foreign central banks introduced to ease stress in U.S. dollar interbank markets abroad.

6. Black Swan in the Money Market TAF announced

7. Limits to Bagehot: Counterparty Risk Despite availability of discount window, Term Auction Facility, and foreign central bank swaps, term interbank rates remained elevated due to counterparty risk. Liquidity policies alone cannot solve solvency problems. Conditions improved in money market only after new government guarantees on bank debt and deposits, infusions of capital into banking system, and uncertainty about situation ebbed.

8. Limits to Bagehot: Solvency

9. Bagehot for the 21 st Century Crisis showed that key short-term funding markets are susceptible to panics and runs similar to banks – Investment banks (Repurchase agreements) – Commercial paper funded by money market mutual funds – Asset-backed Securitization In 2008, Fed instituted discount window lending programs to these markets

10. Extending Access to Capital Markets CPFF and MMIFF introduced

11. Extending Access to Securitization Markets

12. Limits to Bagehot: Collateral In capital market applications, good collateral condition severely restricts scope of programs – CPFF limited to highest quality commercial paper – Limited TALF’s use for real estate MBS With TALF, Treasury took risk position ahead of Fed, increasing size and scope of program.

13. Conclusion Two “cheers” for Bagehot: – Presence of lender of last resort critical to stemming panic in banking. – Extension to segments of capital markets used for short-term funding is an important innovation that proved effective during crisis.

14. Why Only Two “Cheers” ? Limits to Bagehot – Stigma – Solvency vs. liquidity – Collateral requirement can be restrictive in crisis. Risks – Default risk (more than simple liquidity provision). – Central bank unavoidably picks “winners” and “losers” in choosing market segments to lend to. – Blurs distinction from fiscal policy, potentially undermining central bank independence.

15. Critical Issues Moral hazard Non-bank financial institutions and markets now expect to have access to discount window in crisis. Insufficient liquidity management Systemic Risk Supervision – Reduce contagion – Orderly resolution of systemically-important financial institutions – Non-central bank support for systemically-important FI and markets.

17. Choosing Who Has Access

18. Extending Access to Investment Banks

19. Limits to Bagehot: Collateral