The Federal Reserve as Collateral's Last Resort

Notre Dame Law Review Volume 96 Issue 4 Article 1 4-2021 The Federal Reserve as Collateral's Last Resort Colleen M. Baker Assistant Professor of Legal Studies, Price College of Business and Affiliate Faculty, College of Law, University of Oklahoma Follow this and additional works at: https://scholarship.law.nd.edu/ndlr Part of the Banking and Finance Law Commons Recommended Citation 96 Notre Dame L. Rev. 1381 (2021) This Article is brought to you for free and open access by the Notre Dame Law Review at NDLScholarship. It has been accepted for inclusion in Notre Dame Law Review by an authorized editor of NDLScholarship. For more information, please contact . \\jciprod01\productn\N\NDL\96-4\NDL401.txt unknown Seq: 1 9-APR-21 18:03 SYMPOSIUM THE FEDERAL RESERVE AS COLLATERAL’S LAST RESORT Colleen M. Baker* INTRODUCTION Central bank money or liquidity is at the heart of modern economies.1 It is issued against collateral designated as eligible by, and on terms defined by, central bank collateral frameworks,2 which are the focus of this Essay. Walter Bagehot’s well-known dictum posits that in a liquidity crisis, central banks should act as lenders of last resort by lending freely against good collateral at penalty rates. 3 The good collateral requirement ensures that a borrower is illiquid rather than insolvent.4 Yet in a financial crisis, it can be difficult—if not impossible—to distinguish between an illiquid and an insolvent firm. However, what is often underappreciated is that the ultimate practical difference between an illiquid and an insolvent firm is whether a firm has assets a central bank, such as the Federal Reserve, will accept as collateral for lending or for purchase, and at what valuation. What ultimately constitutes “good” or central bank “eligible” collateral, how best to assess its value, © 2021 Colleen M. Baker. Individuals and nonprofit institutions may reproduce and distribute copies of this Essay in any format at or below cost, for educational purposes, so long as each copy identifies the author, provides a citation to the Notre Dame Law Review, and includes this provision in the copyright notice. * Assistant Professor of Legal Studies, Price College of Business and Affiliate Faculty, College of Law, University of Oklahoma; PhD The Wharton School, J.D./M.B.A. University of Virginia. I wish to thank the Classical Liberal Institute at NYU School of Law and the Notre Dame Law Review for the invitation to participate in this symposium and the participants for their comments. 1 Kjell G. Nyborg, Central Bank Collateral Frameworks 1 (Swiss Fin. Inst. Rsch. Paper Series, Working Paper No. 15-10, 2015), https://ssrn.com/abstract=2576075. 2 Id. 3 See WALTER BAGEHOT, LOMBARD STREET: A DESCRIPTION OF THE MONEY MARKET 196–99 (New York, Scribner, Armstrong & Co. 1873). 4 Kathryn Judge, The Federal Reserve: A Study in Soft Constraints, 78 LAW & CONTEMP. PROBS., no. 3, 2015, at 65, 78 n.69 (explaining that some have interpreted Bagehot’s good collateral requirement to limit such lending to solvent institutions). 1381 \\jciprod01\productn\N\NDL\96-4\NDL401.txt 1382 unknown Seq: 2 notre dame law review 9-APR-21 18:03 [vol. 96:4 and whose perspective on these questions matters most are critical issues at the heart of central bank collateral frameworks. In the financial crisis of 2007–09,5 Federal Reserve officials explained that the investment bank Lehman Brothers lacked the collateral necessary to secure its liquidity assistance.6 Consequently, the bank filed for Chapter 11 bankruptcy on September 15, 2008.7 On the following day, the Federal Reserve rescued the multinational insurer American International Group (AIG).8 Six months earlier, it had rescued the investment bank Bear Stearns.9 All three firms were important players in the shadow banking or market-based credit system.10 To collateralize their significant levels of shortterm borrowing, all three firms had relied upon assets that, in the financial crisis, markets came to view as questionable.11 Once markets lost faith in the quality of the firms’ assets, the firms could no longer secure market funding. The Federal Reserve was their last resort. And the respective histories of these firms attest to the centrality of collateral and central bank collateral frameworks in modern credit markets. The importance of central bank collateral frameworks extends beyond defining the terms upon which central banks provide liquidity or purchase assets. The institutional features of these frameworks, which are a result of legislation and central bank policy, can influence the production, liquidity, and pricing of assets that markets use as collateral.12 Collateral frameworks can also impact market discipline and enable indirect bailouts of firms and governments.13 Those with assets a central bank such as the Federal Reserve will buy benefit from a wealth effect.14 The Federal Reserve recently 5 For simplicity, this Essay uses the phrase “financial crisis” to refer to the financial crisis of 2007–09 unless otherwise noted. 6 See Laurence Ball, The Fed and Lehman Brothers 2 (July 2016) (unpublished manuscript) (https://data.nber.org/data-appendix/w22410/The%20Fed%20and%20Lehman %20Brothers.pdf) (arguing Lehman Brothers had the collateral necessary to secure the central bank’s funding). 7 Id. at 1. 8 Id. at 44. 9 Id. at 26. 10 See id. at 1. 11 See id. at 21–22. AIG’s near collapse is generally discussed in the context of its problematic credit-default swaps activity. See, e.g., William K. Sjostrom, Jr., The AIG Bailout, 66 WASH. & LEE L. REV. 943, 959–61 (2009). However, its securities lending activities also contributed to its troubles. See Hester Peirce, Securities Lending and the Untold Story in the Collapse of AIG 4 (Mercatus Ctr., George Mason Univ., Working Paper No. 14-12, 2014), https://ssrn.com/abstract=2435161. 12 See Kjell G. Nyborg, Collateral Frameworks: The Open Secret of Central Banks, VOXEU (Jan. 24, 2017), https://voxeu.org/article/how-central-bank-collateral-frameworks-distorteconomy. 13 See id. 14 Lev Menand, Unappropriated Dollars: The Fed’s Ad Hoc Lending Facilities and the Rules That Govern Them 25 (ECGI, Law Working Paper No. 518/2020, 2020), https://ssrn.com/ abstract=3602740. \\jciprod01\productn\N\NDL\96-4\NDL401.txt 2021] unknown Seq: 3 9-APR-21 the federal reserve as collateral’s last resort 18:03 1383 announced its intention to continue purchasing assets to support markets and to promote accommodative financial conditions.15 Post–financial crisis reforms and the continuing growth of the marketbased credit system have fueled the importance of collateral securities in global financial markets. Yet while many economists16 and legal scholars17 have analyzed last resort lending by central banks and the shadow banking system itself,18 few have focused on collateral and central bank collateral frameworks.19 This shortfall is problematic. Market participants consider these fra (...truncated)