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 promotes low inflation and full employment; these clear goals reduce uncertainty in financial markets and help financial institutions operate efficiently. Supervision and regulation are essential for keeping banks safe and sound. And 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 enough. At such times, the stabilizing actions of a central bank take on critical and immediate importance. When the financial system is experiencing severe shocks, the Fed is prepared to take extraordinary action to keep disruptions from spreading across 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 changes to open market operations, lending through the “discount window” to eligible banks, and operating special lending facilities for other financial institutions. This is why the Fed and other central banks are known as “lenders of last resort.”
Temporary Open Market Operations and Discount Window Lending
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, 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 available only at elevated interest rates. The Fed can step in on an emergency basis as lender of last resort, providing liquidity to the banking system. For example, it can buy government securities on the open market, thereby injecting money into the banking system. Reserve Banks also can lend directly to depository institutions, transactions known as “discount window” loans. The day after the September 2001 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 market. But when these markets are severely impaired, as happened during the 2007–2008 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 targeted 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. Once financial conditions improved, these relaxed terms for discount window lending were phased out. In response to the COVID-19 pandemic and associated disruptions to financial markets, the Fed again reduced the difference between the interest charged on discount rate loans and the federal funds rate, and extended loans for longer periods.
Special Lending Facilities and Extraordinary Measures
The Great Recession — 2007–2009
The Fed’s response to financial instability must also take into account the evolution of the financial system.
The Fed’s response to financial instability must also take into account the evolution of the financial system. Nonbank financial institutions and securitization markets now play major roles in the financial system, requiring the Fed to expand its range of liquidity programs. In such a rapidly changing environment, the severity of the financial crisis of 2007–2008 prompted the Fed to step beyond its traditional role as lender of last resort to banks. To stabilize the financial system, the Fed implemented a number of temporary emergency lending programs to provide funding to nonbank financial institutions. These included primary securities dealers, money market mutual funds, commercial paper issuers, and purchasers of securitized loans. In addition, the Fed worked with the U.S. Treasury to provide financial support to institutions whose collapse could have threatened the stability of the entire financial system. The Fed carried out these extraordinary measures under the authority of section 13(3) of the Federal Reserve Act, a special provision that permits the Fed to lend to “any individual, partnership, or corporation” in “unusual and exigent circumstances.”
The Dodd-Frank Act — 2010
Under the Dodd-Frank Act, the Fed must get approval from the Treasury Department before exercising its extraordinary lending authority.
With the passage of the Dodd-Frank Act in 2010, the Fed’s authority to carry out emergency measures changed. Under this law, the Fed must get approval from the Treasury Department before exercising its extraordinary lending authority under section 13(3). In addition, the Fed may extend credit under section 13(3) only under a program with broad eligibility. It cannot create programs designed to support individual entities. In addition, to increase transparency, the Fed must identify discount window and special lending program borrowers after a two-year waiting period. To strengthen oversight, the Government Accountability Office must audit the Fed’s discount window and emergency lending programs. Also, the Fed is required to publish detailed accounts of each of its emergency lending programs within one year of the program closing down. These requirements promote the public’s trust in the Fed as responsible, fair, and transparent.
The COVID-19 Pandemic — 2020
Most recently, the Fed responded to disruptions in the financial markets due to the COVID-19 global pandemic. Because of the unprecedented impact of the pandemic on the economy, the Fed took decisive actions to stabilize financial markets and support the economy and its recovery. These actions involved the use of traditional and emergency policy tools.
Using its Section 13(3) emergency lending powers, with approval from the Treasury, the Fed announced nine special lending programs, ranging from the “Primary Dealer Credit Facility” to the “Main Street Lending Program.” As outlined in the graphic below, all of these lending programs were established within the span of 24 days, beginning March 17, 2020. These measures played their intended role of stabilizing financial conditions in the midst of the economic turmoil caused by the pandemic.
- March 3, 2020: FOMC emergency meeting; rate cut
- March 15, 2020: FOMC emergency meeting; rate cut; enhanced discount window lending; large-scale asset purchases; reserve requirements eliminated
- March 17, 2020: Commercial Paper Funding Facility; Primary Dealer Credit Facility
- March 18, 2020: Money Market Mutual Fund Liquidity Facility
- March 19, 2020: Central bank liquidity swaps
- March 23, 2020: Primary Market Corporate Credit Facility; Secondary Market Corporate Credit Facility; Term Asset-Backed Securities Loan Facility
- March 31, 2020: Temporary Foreign and International Monetary Authority Repo Facility
- April 9, 2020: Paycheck Protection Program Liquidity Facility; Municipal Liquidity Facility; Main Street Lending Program
COVID-19 and the Economy, speech by Jerome H. Powell, Chair, Federal Reserve Board of Governors, at the Hutchins Center on Fiscal and Monetary Policy, The Brookings Institution, Washington, D.C., April 9, 2020.
Credit and Liquidity Programs and the Balance Sheet, Federal Reserve Board of Governors, May 24, 2017.
FAQs: Money, Interest Rates, and Monetary Policy, Federal Reserve Board of Governors, March 1, 2017.
Federal Reserve’s Exit Strategy, testimony by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C., February 10, 2010.
The Federal Reserve’s Policy Actions during the Financial Crisis and Lessons for the Future, speech by Donald L. Kohn, Vice Chairman, Federal Reserve Board of Governors, at the Carleton University, Ottawa, Canada, May 13, 2010.
Liquidity Provision by the Federal Reserve, speech by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, at the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, GA, May 13, 2008.
Policy Tools, Federal Reserve Board of Governors, April 15, 2020.
September 11, the Federal Reserve, and the Financial System, speech by Roger W. Ferguson, Jr., Vice Chairman, Federal Reserve Board of Governors, at Vanderbilt University, Nashville, TN, February 5, 2003.