The Federal Reserve: A Lender of Last Resort

 /  Jan. 11, 2021, 9:32 p.m.

Federal Reserve
The Federal Reserve Headquarters in Washington, D.C.

As the COVID-19 pandemic triggered an economic recession, the Federal Reserve Bank—known colloquially as “the Fed”—stepped into its role as the ‘lender of last resort,’ extending aid to households, employers, and even state governments. This has caused heightened debate between Republicans and Democrats over how the Fed should lend in times of crisis, culminating in December’s second major coronavirus relief bill. 

The Fed is the authority responsible for maintaining stability in the US financial system and the major force behind the nation’s monetary policy. Created to be a nonpartisan system of twelve branches and a Board of Governors in 1913, the Fed largely operates out of the public eye, creating minor adjustments in interest rates and monitoring activities of large banks, until times of economic depression when more drastic action is required. The 2008 Great Recession saw a large expansion in the Fed’s power to lend to banks. Credit programs like the Term Auction Facility and Commercial Paper Funding Facility were created by the Fed to provide short-term liquidity to institutions that were deemed stable to prevent more widespread economic damage. 

These programs were controversial at the time, with critics questioning whether institutions that had contributed to the housing crisis deserved to be bailed out and the extent of the Fed’s authority to do so without congressional approval. Amid the current economic crisis, some Republicans want to limit the Fed’s ability to lend, while Democrats argue that the Fed should continue its current course of lending despite mixed practical results.

Lending Programs in the First COVID Stimulus

In late March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, setting in motion five key lending programs under the Fed’s purview. Much like in 2008, they were instrumental in ensuring stability in both small and large companies and helped to prevent a widespread panic. Politicians on both sides of the aisle have agreed that the programs approved in March were necessary given the high unemployment and quickly falling faith in institutions at the time. 

The first was the Primary Market Corporate Credit Facility (PMCCF), which targeted investment-grade companies struggling to stay afloat in the pandemic by providing loans and purchasing corporate bonds with a four-year maturity. The Secondary Market Corporate Credit Facility (SMCCF) served as a counterpart to the PMCCF. It focused on eligible bonds as well as exchange-traded funds, which are essentially portfolios of corporate bonds. The difference between the programs lies in the fact that the latter deals in the secondary market, where the financial instruments being bought and sold were originally issued in the past. 

The third initiative, the Municipal Liquidity Facility (MLF), provided liquidity to state, county, and city governments by buying short-term debt notes for larger local communities. The Main Street Lending Program (MSLP) was created to lend to small- and medium-sized businesses and non-profit organizations. The three facilities aimed at businesses in the for-profit sector—Main Street New Loan Facility, Main Street Priority Loan Facility, and Main Street Expanded Loan Facility—respectively address companies seeking loans ranging from $100,000-$35 million, $100,000-$50 million, and $10-$300 million. The final program, the Term Asset-Backed Securities Loan Facility (TALF), was created to help consumers and businesses to meet financial obligations by issuing asset-backed securities, which are packages of loans that are then sold to investors to raise capital. 

The results have been mixed, with limited use of the direct lending programs for smaller businesses and households. However, the purchasing of corporate bonds through the PMCCF and SMCCF had the noticeable effects of bringing down borrowing costs in the private sector, encouraging liquidity, and causing a sudden uptick in the stock market following the initial crash in March. Programs aimed at larger businesses have generally had more practical value, and big corporations have successfully built up cash reserves in recent months. In contrast, the MSLP and its facilities for small “main street” businesses has been widely criticized for having little practical use as its main customers have continued to depend on banks due to the strict rules and regulations created by the Fed. Republican lawmakers have argued that the general lack of use of the lending facilities indicates that they do not need to be renewed, whereas Democrats suggest that the existence of the facilities as a fallback option provides a sense of security in a loan market that is still very volatile. 

A Rocky Road To The Second Stimulus

With many CARES Act benefits set to end and a new fiscal year beginning, negotiations over the 2021 federal budget and a renewed stimulus package finally ended with the signing of the Consolidated Appropriations Act of 2021 into law on December 27. Republicans stirred debate in Washington earlier in the month by pushing for a provision in the relief bill that would bar the Fed from automatically restarting these programs in 2021. After the CARES Act passed, the Fed did not make as many loans as expected, as citizens and small businesses instead depended more on the Fed’s programs that bought debt. 

Treasury Secretary Steven Mnuchin requested that the Fed transfer the $455 billion of unspent money allocated through the CARES Act to a special account that would require congressional approval. Federal Reserve Chairman Jerome Powell has agreed to the returning of funds, though it remains murky whether Mnuchin’s actions are legal, as the Fed is meant to operate as a nonpartisan institution making decisions based on expert opinions rather than the political opinions on spending of elected representatives. The funds will be held in a general account for use at a later date, accessible only by Congress, once the transfer has been completed.

The Trump Administration and Republican Senator Pat Toomey led the charge for the federal lending programs to end on December 31, 2020. Toomey threatened to derail the passing of the new relief bill unless the previously established lending programs were shuttered in the new year as planned. 

In response, the Fed issued a statement saying that they “would prefer that the full suite of emergency facilities established during the coronavirus pandemic continue to serve their important role as a backstop for our still-strained and vulnerable economy.” Republicans favoring ending the programs have argued that the unused funds could be repurposed more efficiently and that the economy is showing signs of a strong recovery, indicating that the same level of aid is not required. The Fed’s own projections for 2021 have improved in most metrics since the summer. The estimated unemployment rate for the end of 2020 has fallen to 6.7 percent, down from 7.6 percent in September and 9.3 percent in June.

In contrast, prominent Democratic senators like Senator Elizabeth Warren and expected members of the incoming Biden Administration like Brian Deese, the proposed National Economic Council director, spoke out in favor of continuing the existing lending programs. Warren argued at a September banking hearing that though the aggregate economic outlook for the new year has improved marginally, minority communities have been hit the hardest and are seeing a slower recovery. 

Some lawmakers accused Mnuchin of acting out of malice to sabotage the new government by forcing the long process of passing legislation on Fed policy in a stimulus bill requiring more immediate attention. Democratic Senator Bob Menendez, a senior member of the Senate Banking Committee, said: “While Senate Democrats have been demanding the Trump Administration send a full-sized rescue boat to keep the economy afloat during this COVID crisis, Treasury opted instead to toss out a thin life line to keep many struggling businesses and local governments from going under. Now, by cutting that line, the Trump Administration is effectively sitting back to watch our economy drown.” 

The second major federal relief bill was passed on December 21 after Toomey, who initially proposed terminating the existing loan programs, and Democratic Senate Minority Leader Chuck Schumer completed their negotiations. In a major concession from the Democrats, the bill will terminate four of the Fed’s credit lending facilities: the PMCCF, the SMCCF, the Municipal Credit Facility, and the MSLP. Toomey agreed to narrow this legislation’s language on replicating the programs under the new administration, leaving room for the possibility that they will be reestablished by the Fed in 2021. 

In a December 16 press conference on forward-looking monetary policy, Powell also clarified that the Fed would “have the ability to do facilities under 13(3), in some cases with no backing, but we can’t do any 13(3) facilities without the approval of the Treasury Secretary.” This refers to Section 13(3) of the Federal Reserve Act, which allows the Fed to provide lending services to commercial banks in “unusual and exigent circumstances” and gave the Fed the authority to pursue the five new lending programs under the CARES Act.

Though the passing of this secondary relief package will provide necessary aid to many Americans who are struggling financially, the Fed will continue to play an important role in maintaining stability for households and businesses alike. With Powell’s term set to end in 2022 and an incoming Biden Administration that has already publicly supported his calls for greater lending power, it is likely that the lending programs will be reestablished. In the longer run, however, questions remain regarding the extent of the Fed’s ability to exercise Section 13(3) and create economic policy without the supervision of the government’s legislative branch. 

The image featured in this article is licensed for reuse under the Creative Commons Attribution-Share Alike 2.5 Generic license. No changes were made to the original image, which was taken by Dan Smith and can be found here

Niharika Iyer


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