The Fed's day-to-day activities of conducting monetary policy, supervising and regulating banks, and providing payment services all help maintain the stability of the financial system. Sound monetary policy helps promote a stable, low inflation environment and dampen business cycle fluctuations, which reduces financial market turbulence and helps keep financial institutions healthy. Supervision and regulation are essential for keeping banks safe and sound. The Fed's role in the nation's payments system provides for the smooth execution of billions of transactions every day.
During periods of acute financial strain, these activities may not be sufficient. At such times, the stabilizing actions of a central bank take on critical and immediate importance, as we learned in the aftermath of the terrorist attacks in September 2001 and during the recent financial crisis. When the financial system is experiencing great shock, the Fed is equipped to take extraordinary action to keep disruptions from spreading within the financial sector and from spilling over to the broader economy. Specifically, the Fed is prepared to provide liquidity, that is, emergency access to cash, to financial markets and institutions in a number of ways. These include temporary adjustments in the duration or size of open market operations, lending through the “discount window” to eligible financial institutions, through special lending facilities to other institutions, as well as other extraordinary measures. This is why the Fed and other central banks are known as "lenders of last resort."
The Fed can step in on an emergency basis as lender of last resort, providing liquidity to the banking system.
When the normal functioning of financial markets is disrupted or when banks and other depository institutions are experiencing unusual stress, financial institutions may be hard pressed to get the funds they need to finance day-to-day operations. Private credit markets may seize up, making loans unavailable at reasonable prices. The Fed can step in on an emergency basis as lender of last resort, providing liquidity to the banking system. The Fed can serve this function in a number of ways. It can buy government securities on the open market, thereby injecting money into the banking system. Reserve Banks can lend directly to depository institutions, transactions known as "discount window" loans. The day after the September 11 terrorist attacks, discount window lending totaled more than 200 times the daily average for the previous month. In such a crisis situation, the Fed's role as liquidity provider helps to restore confidence in the financial system by enabling banks to meet their short-term payment obligations.
In normal times, banks borrow from the discount window only when they are having trouble raising funds in the private markets. But when the interbank lending markets are severely impaired, as happened during the recent financial crisis, the discount window can become the primary source of funds for many banks at the same time. To make it easier for banks to borrow through the discount window during the crisis, the Fed implemented a number of changes. These included reducing the difference between the interest charged on discount rate loans and the Fed’s target for the federal funds rate, extending loans for longer periods, and conducting auctions for discount window credit. As financial conditions improve, these relaxed terms for discount window lending are being gradually phased out.
The Fed's response to financial instability must also take into account the evolution of the financial system over time.
The Fed's response to financial instability must also take into account the evolution of the financial system. That system has changed considerably in recent decades. Nonbank financial institutions and securitization markets now play a major role. In such a rapidly changing environment, the severity of the recent financial crisis prompted the Fed to step beyond its traditional role as lender of last resort to banks. To stabilize the financial system, the Fed implemented several extraordinary measures. These included creating a number of temporary emergency lending programs to provide funding to nonbank financial institutions, such as primary securities dealers, money market mutual funds, commercial paper issuers, and purchasers of securitized loans. In addition, to prevent the failure of institutions whose collapse would have threatened the entire financial system, the Fed worked with the U.S. Treasury to provide financial support. These extraordinary measures were undertaken under section 13(3) of the Federal Reserve Act, a special provision that permits the Fed to lend to individuals, partnerships, and corporations in "unusual and exigent circumstances.”
Under the Dodd-Frank Act of 2010, the Fed must obtain approval from the U.S. Treasury before using its extraordinary lending authority.
The recently enacted Dodd-Frank Act changes the Fed's authority to carry out emergency measures. Under the new law, the Fed must get approval from the Treasury Department before exercising its extraordinary lending authority. In addition, the Fed may extend credit under section 13(3) only under a program with broad eligibility. It can’t create programs designed to support individual institutions. To increase transparency, the Fed must identify discount window and special lending program borrowers after designated periods. To strengthen oversight, the Government Accountability Office is auditing the Fed's discount window and emergency lending programs.
Through its membership in the newly created interagency Financial Stability Oversight Council, the Fed will help identify potential risks to the stability of the financial system and develop measures to control those risks.