Should the Fed Lend to Investment Banks?

Includes: C, GS, JPM, MER, MS
by: Zubin Jelveh

The FT reports that investment banks are split over whether the benefits of having access to a special Federal Reserve lending facility outweigh the costs of expected tighter regulation if the facility is made permanent.

But it's worth looking at this question from the other side: What does the Federal Reserve get out of lending to I-banks? The answer thus far seems to be not much.

Since the markets squeezed up in August, the Fed has introduced three new lending facilities to bring back liquidity to markets:

  • The Term Auction Facility introduced in December was intended to take the stigma out of borrowing from the discount window.
  • In a space of one week in March, the Fed created the Term Securities Lending Facility and the Primary Dealer Credit Facility. The TSLF allowed primary dealers to trade risky mortgage-backed securities for Treasuries, and the PDCF allowed investment banks to borrow from the Fed for the first time.

How helpful was each of these in bringing order back to markets? One controversial paper by John Taylor of Stanford and John Williams of the San Francisco Federal Reserve earlier this year argued that there was no empirical evidence that the TAF had helped reduce the spread in a key measure of liquidity: the difference between the overnight inter-bank lending rate and London inter-bank offer rates.

But this finding has come under criticism with Bill Dudley of the New York Fed saying this month that the John-John study was poorly designed:

the paper tests whether there was an impact on the spread only on the day of the auction, not before--with the announcement--or after, when the auction results are announced or when the auctions settle.

The problem with this setup is that it ignores the possibility that the Fed loans relieved credit tightness on days besides auction days. Since the loans obtained from TAF last four to five weeks, it'd make sense that liquidity could be improved during non-auction days. Now, a new paper from Dallas Fed economist Tao Wu looks at this and finds that the spread studied by Taylor and Williams did indeed fall significantly after the TAF was introduced, implying that the TAF helped bring some measure of liquidity back to markets.

This chart from the paper shows the Libor and overnight inter-bank lending rate spread since the credit crunch started:


So while it's clear that spreads fell after TAF, they headed north again in early 2008. That doesn't mean, however, that the TAF failed, argues Wu, because its intention was to ease banks' liquidity concerns. The driving force behind higher spreads in '08 was counterparty risk. The TAF, and neither the TSLF nor the PDCF could alleviate that.

Support has grown in recent month for making the TAF a permanent part of the Fed's toolkit. It might still be too early to piece apart the full effects of the TSLF and the PDCF, but early indications are that it wouldn't be the end of the world if they were allowed to go the way of Bear Stearns.

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