THE FEDERAL RESERVE AS COLLATERAL'S LAST RESORT.

• Author: Baker, Colleen M.

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, 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 short-term 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 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 market-based credit system have fueled the importance of collateral securities in global financial markets. Yet while many economists (16) and legal scholars (17) 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 frameworks a key consideration in collateral markets. (20)

This Essay begins to close this gap in the legal scholarship. As it explains, collateral frameworks are institutional features of central banks that define the terms upon which central bank money is allocated in modern economies. Such allocations not only have survival implications for firms such as Lehman Brothers, but they can also impact credit allocation (21) and wealth distribution in society. (22) Increased academic scrutiny of these foundational frameworks should help to promote central bank transparency, accountability, and oversight. (23)

This Essay is the first step in a broader normative project analyzing the proper balance between legislation and central bank policy--between architecture and implementation--in shaping the Federal Reserve's collateral framework to best promote market discipline and to minimize credit allocation. Its modest aim is twofold. First, it provides the first analysis of central bank collateral frameworks in the legal scholarship. Second, it analyzes the equilibrium between legislation and central bank policy in the Federal Reserve's collateral framework in the context of its section 13(3) emergency liquidity authority, lending authority for designated financial market utilities, and swap lines with foreign central banks, and general implications of these arrangements.

Part I addresses the role of collateral in financial markets, specifically in the market-based credit system. Part II turns to central bank liquidity provision and collateral frameworks, particularly in the context of the Federal Reserve. It demonstrates that via their collateral frameworks, central banks such as the Federal Reserve act in and are acted upon by markets. Part III analyzes the equilibrium between legislation and central bank policy in the Federal Reserve's collateral framework in the context of three emergency facilities and general implications of these arrangements. The Essay then concludes.

1. COLLATERAL AND THE SHADOW BANKING/MARKET-BASED CREDIT SYSTEM

   This Part first provides a brief overview of collateral's central role in the shadow banking or market-based credit system. It then examines the system's fragility and the instability triggered by problems in collateral flows.

   1. Sketch of the Shadow Banking System

      As the shadow banking system grew prior to the financial crisis, collateral use by markets "rose exponentially," (24) especially levels of "cash equivalent instruments." (25) The shadow banking (26) or market-based credit system now provides as much credit--if not more lending--than the traditional banking system. (27) However, the systems are symbiotic. Prior to the financial crisis, "[l]arge banks sponsored shadow banking entities such as Structured Investment Vehicles (SIVs), money market funds, asset-backed commercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system." (28) The systems' interconnectedness risks the transmission of vulnerabilities and shocks between them. (29) For example, in the financial crisis, shadow banking institutions turned to the traditional banking system for credit and liquidity assistance (30) via lines of credit when investors pulled back from funding their securities. (31) Since the financial crisis, the shadow banking system has only continued to increase in volume, (32) and in its "products, services, and financial models." (33) Its growth has "relied on the increased use of collateral as complementary 'liquid' assets beyond bank reserves." (34)

      In the shadow banking system, financial intermediation occurs via securities markets rather than depository institutions. In many ways, the shadow banking system looks, smells, and acts like traditional banking. A significant part of it consists of short-term lending via repurchase agreements ("repo") that is used to fund longer-term securities assets. The accompanying reuse of securities collateral is "identical to the money creation that takes place in commercial banking through the process of accepting deposits and making loans." (35) Collateral flows drive credit creation as much as money itself. (36) The arrangement mimics the traditional banking system's use of short-term lending (via demand deposits) to fund longer-term assets. Consequently, it also has the fragile maturity mismatch between liabilities and assets at the heart of the traditional banking system that creates the risk of bank runs and financial instability.

   2. The Fragility of the Shadow Banking System

      However, the shadow banking system is not regulated like the traditional banking system. It is also not explicitly encompassed within the federal government's safety net for depository institutions. (37) Instead, this safety-net role is supposedly played by cash-like or cash-equivalent securities used as collateral, a traditional private market self-help mechanism. Due to the shadow banking system's foundational reliance on collateral, bank-like regulation originally seemed unnecessary. It was assumed that market forces would control risk taking in this system. (38) Hence, borrowed funds (often via repo transactions) were not--and still are not--protected by federal deposit insurance nor do shadow banks have access to the Federal Reserve's discount window, a standing liquidity facility, if their funding dries up. However, as recent crises have demonstrated, private market securities collateral often loses its "cashlike" or "cash-equivalent" status and becomes information sensitive (illiquid) in stressed markets. When this happens, a liquidity crisis, which could lead to a credit crisis, ensues.

      As collateral flows are at the core of liquidity in the shadow banking system, they impact financial market stability. (39) Hence, the increased incidence of credit provided by securities markets challenges traditional limits of central bank collateral frameworks. To provide assistance to this system, central banks must lend to a broader array of counterparties and against a greater variety of collateral than they traditionally would. Major central banks such as the Federal Reserve have taken actions, such as large-scale asset purchases, to assist this system, now giving them a "substantial footprint" in collateral markets. (40)

      Financial assets act as "a storage facility for liquidity." (41) However, liquidity is dynamic and valuable. (42) When market participants have access to liquidity insurance via central bank liquidity facilities, their...