The Federal Reserve Board has used Section 13(3) of the Federal Reserve Act to create several new lending facilities to address the ongoing strains in the credit market.Financial crises ; Credit

Craig P. Aubuchon

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2009 ￿ Number 06
“In unusual and exigent circumstances, the Board of
Governors of the Federal Reserve System…may authorize
any Federal reserve bank…to discount for any individual,
partnership, or corporation, notes, drafts, and bills of
exchange when such notes, drafts, and bills of exchange
are indorsed or otherwise secured to the satisfaction of
the Federal reserve bank: Provided…that such individual,
partnership, or corporation is unable to secure adequate
credit accommodations from other banking institutions.”
—Federal Reserve Act §13(3)
U
.S. house prices peaked in April 2007, as measured
by the Federal Housing Finance Agency’s Purchase-
Only House Price Index. As U.S. house prices flat-
tened, and then declined, U.S. financial institutions exposed
to mortgages and mortgage-related investments began to
experience financial distress. By August 2007, the Federal
Open Market Committee acknowledged the growing credit
stress, noting that, “In current circumstances, depository
institutions may experience unusual funding needs because
of dislocations in money and credit markets.”1
Since then, the strain in credit markets has intensified.
Under normal conditions, banks borrow and lend money
to individuals and institutions. However, with the current
economic environment, banks, institutions, and individuals
are unsure of each other’s ability to repay a loan or invest-
ment. This risk manifests itself in both higher interest rates
(the cost of borrowing money) and tighter lending standards.
Economists and policymakers often gauge the severity of
credit stress by the spread between the London Interbank
Overnight Rate (LIBOR) and the federal funds rate. LIBOR
is the interest rate that banks charge on loans to one another;
the federal funds rate is the interest rate on loans of surplus
reserves at Federal Reserve Banks. Under normal condi-
tions, these rates are similar; but at times during the past
year, the overnight LIBOR has been much higher than the
federal funds rate because of perceived increased credit risk
in financial markets. When interbank interest rates rise and
banks tighten lending standards, individuals and businesses
find it more difficult and costly to borrow for both personal
consumption and business development.
Federal Reserve Actions
The Federal Reserve Board has used Section 13(3) of the
Federal Reserve Act to create several new lending facilities
to address the ongoing strains in the credit market. These
facilities have complemented traditional policy actions
undertaken during the same period. Section 13(3) requires
that banks be “unable to secure adequate credit” from other
sources. Thus, the Fed is considered the “lender of last
resort.” Since August 2007, the Fed has addressed credit
distress in three ways: by extending the duration of loans,
increasing acceptable collateral, and extending the reach
of lending beyond primary dealers. 
The Initial Expansion: 
Extending the Duration of Loans 
On August 17, 2007, the Fed increased the borrowing
term on primary credit to 30 days, well beyond the tradi-
tional overnight discount window loan. Then, on
December 12, 2007, the Fed introduced the Term Auction
Facility (TAF) also to provide funds for a longer duration—
for terms of 28 and 84 days. The TAF allows interested
depository institutions to participate in an auction—the low-
est bid that allocates all available funds becomes the inter-
est rate on the loan for all borrowers. As of December 31,
2008, $450.2 billion in term auction credit was outstanding
on the Fed’s balance sheet.
The Second Expansion: 
Increasing Acceptable Collateral
On March 11, 2008, the Fed initiated the second type
of new lending by expanding acceptable collateral through
the Term Securities Lending Facility (TSLF). The TSLF
makes funds available at 28-day maturity and accepts as
collateral a wide range of residential mortgage–backed
securities. Another expansion of collateral, the Primary
Dealer Credit Facility (PDCF), was established on March
16. The PDCF provides overnight financing similar to the
discount window, but accepts any assets deemed to be col-
lateral by other major clearing banks. Most recently, on
The Fed’s Response to the Credit Crunch 
Craig P. Aubuchon, Senior Research AssociateNovember 25, 2008, the Fed again expanded the definition
of acceptable collateral under the Term Asset-Backed
Securities Lending Facility (TALF), which accepts highly
rated assets backed by student loans, auto loans, credit card
loans, and loans guaranteed by small businesses. One goal
of this program is to help support the market for these assets
and lower interest rate spreads for consumers and small
businesses.
The Third Expansion: 
Extending the Reach of Lending Facilities
The Fed introduced the third expansion of lending in
September 2008. Following the bankruptcy of Lehman
Brothers on September 15, credit conditions deteriorated
further, particularly in the markets for short-term financing
by corporations. Often, businesses issue commercial paper
to fund their operations, such as payroll obligations. Money
market mutual funds play a major role in this market, pur-
chasing commercial paper from creditworthy companies
and using the interest payments on the commercial paper
to provide a steady rate of return. By late September, the
perception of increased risk caused money market funds
to reduce their purchases of commercial paper, which left
many corporations unable to finance their operations. To
address these liquidity concerns, the Fed created three pro-
grams to extend the scope of its lending beyond primary
dealers.
The first facility, known as the AMLF,2 allows money
market mutual funds to sell commercial paper to banks and
then allows those banks to post the commercial paper as
collateral for loans from the Fed. This guaranteed market
allows banks and money market mutual funds to confi-
dently trade in commercial paper. The second facility, the
Commercial Paper Funding Facility (CPFF), buys commer-
cial paper directly from corporations at a term of three
months. The Fed announced that the CPFF will purchase
up to $1.8 trillion over the next several quarters; as of
December 31, 2008, the Fed had purchased $332.4 billion
of commercial paper from companies. The Money Market
Investor Funding Facility (MMIFF), announced on
October 21, 2008, is the third program implemented by the
Fed; this program facilitates the purchase of commercial
paper from money market mutual funds directly. These
three facilities help to reduce the costs of borrowing for
businesses during their daily operations.
No Quick Fix
In the past year, the Fed has significantly expanded its
lending activities by extending the duration, collateral,
and scope of its programs. Federal Reserve Chairmen Ben
Bernanke noted in his testimony before Congress on
November 18 that “credit markets, while still quite strained,
are improving. Interbank short-term funding rates have
fallen notably since mid-October, and we are seeing greater
stability in money market mutual funds and in the commer-
cial paper market.” No single facility can provide an instant
fix to an ailing economy. Rather, each facility addresses a
particular liquidity constraint in the financial markets. ￿
1 See August 10, 2007, Federal Open Market Committee press release.
2 Asset Backed Commercial Paper (ABCP) Money Market Mutual Fund (MMMF)
Liquidity Facility; AMLF.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on January 15, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
“The Federal Reserve Board has used
Section 13(3) of the Federal Reserve
Act to create several new lending 
facilities to address the ongoing
strains in the credit market.”

The Fed's response to the credit crunch

http://research.stlouisfed.org/publications/es/09/ES0906.pdf

The Fed's response to the credit crunch

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