THE FINANCIAL IMPACT OF LENDER‐OF‐LAST‐RESORT BORROWING FROM THE FEDERAL RESERVE DURING THE FINANCIAL CRISIS

• Date: 01 June 2016
• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/jfir.12092

THE FINANCIAL IMPACT OF LENDER-OF-LAST-RESORT BORROWING

FROM THE FEDERAL RESERVE DURING THE FINANCIAL CRISIS

Benjamin M. Blau

Utah State University

Scott E. Hein

Texas Tech University

Ryan J. Whitby

Utah State University

Abstract

The U.S. Federal Reserve (Fed) was reluctant to release the names of firms that

borrowed, and the amounts borrowed, from the emergency loan facilities during the

financial crisis. We show that when the details of this information were finally made

public by the Fed, there was no stock market reaction, contrary to the thought that this

was valuable information. However, further investigation shows that stock returns for

publicly traded borrowing institutions declined significantly and almost immediately

after the Fed borrowing was initiated, although the information had not been made

public by the Fed at the time. The underperformance of borrowing institutions was

greatest for those that received the largest loans or had the largest amount of loans

outstanding. This evidence is consistent with the idea that investors were able to trade on

the information about the Fed’s emergency loan program, although the Fed purposely

tried to keep the information private.

JEL Classification: G01, G10, G20, G28

I. Introduction

Like much of the existing literature in finance, the broad purpose of this research is to

investigate how financial markets incorporate information into market prices. A key

distinguishing feature of our study is that we examine how private (vis-

a-vis public)

information flows into stock prices. In our investigation, we uncover evidence that the

stock prices of institutions that borrowed from the U.S. Federal Reserve (Fed) during

the recent financialcrisis seemed to quickly incorporateinformation about the details ofthe

lending that the Fed attempted to keep private. Specifically, borrowing firms are foundto

suffer stock price declines almost immediately after the firm borrowed from the Fed.

We acknowledge the helpful comments of Kyle Allen, Will Armstrong, Frank Caliendo, Laura Cardella,

George Cashman, Jack Cooney, Ken Cyree, Bob DeYoung, Mike Erickson, Scott Findley, Scott Frame, Robert

Jordan, Junyoup Lee, Jeff Mercer, Mark Moore, Brett Myers, Dan Thornton, Paula Tkac, Larry Wall, David

Wheelock, Matthew Whitledge, Arthur Wilmarth, Drew Winters, and two anonymous referees.

The Journal of Financial Research Vol. XXXIX, No. 2 Pages 179–206 Summer 2016

179

© 2016 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

During the past two decades, there has been a movement by central banks around

the world to increase the level of transparency in their monetary policy actions and thus

provide more public information about their actions (Svensson 1999; Geraats 2002;

Blinder et al. 2008). For instance, central banks in Australia, Brazil, Canada, Chile,

Mexico, New Zealand, Spain, and Sweden adopted the policy of publishing inflation

targets during the 1990s. Crowe (2010) shows empirically that transparent policies, such

as inflation targeting, provide economic benefits by reducing information asymmetries

between policy makers and economic agents. A survey in Fry et al. (2000) reveals that

nearly three-fourths of central banks around the world consider transparency a “vital

component”of their policy framework.

Similar to other central banks, the Fed has recently increased the transparency of

its monetary policy by providing more public information to market participants.

1

For

example, the Fed now announces its target for the federal funds rate, whereas it did not

provide this explicit information to the public until the mid-1980s. More recently, instead

of stating only a given range, the Fed now states an explicit target inflation rate of 2%.

Although the Fed’s level of transparency and public information provision about

monetary policy decisions have been increasing, the Fed was reluctant to release to the

public information about the specific borrowers from its emergency lending programs

during the recent financial crisis, releasing neither the identity nor the amount borrowed

either incrementally or entirely.

The motivation for withholding information from the public about the identity of

the borrowers and the amount borrowed appears to have been driven by fear that the news

could have caused a “bank run”on the borrowing institution. Knowledge of a bank’s

participation in either of the Fed’s lender-of-last-resort facilities could have provided an

unfavorable signal to both financial markets and depositors, which could have reduced

public confidence in the stability of the participating bank.

2

Empirical research tends to

support this contention of a stigma associated with borrowing from the Fed (Peristiani

1998; Furfine 2001; Darrat et al. 2004; Armantier et al. 2011).

As anecdotal evidence of the idea that the Fed wants to increase transparency while

carefully managing the stigma associated with participation in the various Fed lending

programs, Chairman Ben Bernanke testified before the U.S. Congress in February 2010:

We are also prepared to support legislation that would require the release of the identities

of the firms that participated in each special [emergency lending] facility after an

appropriate delay. It is important that the release occur after a lag that is sufficiently

long that investors will not view an institution’s use of one of the facilities as a possible

indication of ongoing financial problems, thereby undermining market confidence in the

1

Although Thornton (2003) questions the wisdom of seeking to achieve increased monetary policy

transparency as an end goal, recent speeches have highlighted the importance of Fed transparency (see, e.g., http://

www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm) in the eyes of many. Blinder et al. (2008)

further document moves by the Fed to enhance transparency.

2

The Fed, as well as the federal government, instituted a variety of emergency lending programs during the

financial crisis aimed at both depository and nondepository institutions. The analysis in this study focuses on Fed

programs that are similar in nature to the lender-of-last-resort funding. Cyree, Griffiths, and Winters (2013)

examine Fed emergency lending programs aside from the two we investigate.

180 The Journal of Financial Research