Document Type

Working Paper

Publication Date

2015

Abstract

Insufficient liquidity can trigger fire sales and wreak havoc on a financial system. To address these challenges, the Federal Reserve (the Fed) and other central banks have long had the authority to provide financial institutions liquidity when market-based sources run dry. Yet, liquidity injections sometimes fail to quell market dysfunction. When liquidity shortages persist, they are often symptoms of deeper problems plaguing the financial system. This Essay shows that continually pumping new liquidity into a financial system in the midst of a persistent liquidity shortage may increase the fragility of the system and, on its own, is unlikely to resolve the deeper problems causing those liquidity shortages to persist. This Essay suggests that when facing persistent liquidity shortages, the Fed should instead use the leverage it enjoys by virtue of controlling access to liquidity to improve its understanding of the ailments causing the market dysfunction to persist and to help address those underlying issues. When liquidity shortages persist, they will often indicate that market participants lack critical information about risk exposures or that they are concerned financial institutions or other entities lack sufficient capital in light of the risks to which they are exposed. Providing credible information and working with other policymakers to ensure the overall financial system is sufficiently capitalized are thus among the issues that the Fed should prioritize when facing persistent liquidity shortages. This Essay thus provides a new paradigm for how the Fed can utilize its lender-of-last-resort authority to prevent a nascent financial crisis from erupting into one that inflicts significant harm on the real economy. The heart of this Essay brings these dynamics to life through a close examination of the Fed’s actions during the early stages of the 2007--2009 financial crisis (the Crisis). Using transcripts from Fed meetings and other primary materials, the Essay reconstructs the first thirteen months of the Crisis. The analysis reveals more than a year during which Fed officials could have taken an array of actions that may have reduced the size of the Great Recession and the amount of credit risk and moral hazard stemming from the government’s subsequent interventions. The analysis also demonstrates specific ways that the Fed’s lender-of-last-resort authority could serve as the type of responsive and dynamic regulatory tool that the Fed requires when seeking to restore stability during the early phases of a panic.

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