Rightsizing the Fed’s emergency lending powers

Below is a lightly edited transcript of the podcast:

JOHN HELTMAN: Are you driving?

JIM DONLAN: No, I’m parked.

HELTMAN: You’re ready? You good?

DONLAN: I’m good now. Yes.

HELTMAN: This is Jim Donlan.

DONLAN: Yes, my name is Jim Donlan, And I’m the owner of SPH solutions.

HELTMAN: And what’s SBH solutions?

DONLAN: SPH solutions is a solar developer, owner-installer of solar arrays and renewable energy. We work mainly with nonprofits, schools, and religious entities, and other not for profits that need to put — or would like to put — solar on their roof to offset their electric cost to be carbon neutral at some point and to improve the environment.

HELTMAN: SPH Solutions — based near Columbia, Md. — found itself in a difficult spot last year.

DONLAN: A majority of our equipment comes from overseas, in China. And so shutting down imports impacted the flow of material. Some of the vendors shifted from a sort of pay-as-you-go to pay-upfront model to get things. And so it was more of the delivery of equipment — and some … some of our clients because of the pandemic restricted our ability to work on their spaces, just because they know a lot of …


DONLAN: … things were unknown. So people just said “No, we don’t want any anybody on campus, except for those that are required.” So we delayed a couple projects because of that.

HELTMAN: Donlan needed funding, and he ultimately got it directly from the Federal Reserve — or more specifically through the Fed’s Main Street Lending Program — a lending facility created a year ago, in the early days of the Coronavirus pandemic, to infuse capital into an economy that had suddenly ground to a halt.

DONLAN: I think there was four banks that were processing it on the East Coast that I contacted, and got some information from each one of them. And it depended — each one had a different criteria of requirements. Some were … because Main Street Lending Program went all the way down to $200,000 or $250,000, of lending up to a couple hundred … 100 million I believe. And I and some of those entities were, we’re not doing anything under this $5 million range, some were doing it starting at $20 million. And so the each one had a different on … on ramp, and I didn’t qualify, my business didn’t qualify for three of the four because we weren’t large enough. And Bank of America was one of those, and Bank of America looked at my portfolio of projects look at where we were financially and came up with a program when we went into the Main Street Lending Program with about $1.25 million.

HELTMAN: This episode isn’t about solar energy or the pandemic or the economy. It’s not even about the Main Street Lending Facility — not really. It’s about section 13(3) of the Federal Reserve Act, a section that empowers the Fed to make emergency loans beyond the banking system — to broker/dealers, cities and even nonfinancial companies like SPH Solutions. It’s a way for the Fed to inject money into whatever section of the economy needs help, and historically, the Fed had used that authority very rarely. But between the bailouts of the 2008 financial crisis and the various lending facilities that were established during the pandemic, questions are starting to emerge about what the appropriate range of motion should be for the Fed to effectively and accountably respond to unforeseen calamities in the financial system.

From American Banker, I’m John Heltman, and this is Bankshot, a podcast about banks, finance, and the world we live in.

HELTMAN: The Federal Reserve does a lot of things. It manages the Federal Funds Rate and the money supply, it conducts original economic research, it regulates many of the country’s largest banks, it operates and regulates the payments system, it has a surprisingly expansive art collection, oddly enough — and there’s more. But one power that the Fed has — and it’s more implied than explicit — is that it holds the fire extinguisher for when critical functions in the economy break down.
That power to intervene in the economy manifests itself in different ways. On the more incremental side, it raises and lowers interest rates through the Federal Open Markets Committee, tightening or loosening the availability of credit as the circumstances require. But when things go really wrong, it can serve as the lender of last resort. That means banks can trade cash for securities through what is known as the Fed’s discount window. And the Fed can do something similar for nonbanks according to section 13(3) of the Federal Reserve Act.
The Fed didn’t always have that power, though.

GEORGE SELGIN: It was added later. Yes. 13. Three was added in 1932, I believe, and then it was also another emergency lending provision that I’ve talked about that was added later in. I think … I want to say, ’34. It’s been a while since I checked. And but both of them date from the New Deal.

HELTMAN: Welcome back to the program George Selgin.

SELGIN: I’m George Selgin. I’m the director of Cato’s Center for Monetary and Financial alternatives. And we handle our monetary policy and banking policy work.

HELTMAN: Section 13(3) — or rather, part 3 of section 13 of the Federal Reserve Act — was added by Congress in 1932 in response to the Great Depression, and then amended again in 1935 (close enough, George). And the reason for that addition, in the context of the Great Depression, may seem obvious.

SELGIN: Nonbanks were said to be suffering for lack of credit. And there was a perception that the private marketplace — the private banks — were not able to, or not willing to, lend adequately to businesses. So the belief was that by having the Federal Reserve step in, it could fill the gap. There was another organization, the Reconstruction Finance Corporation, which had been created earlier, that also was lending to nonbank enterprises. But it was perceived also to have left some gaps. Anyway, in those days, the Fed was given original 13(3) powers. But the powers were interpreted very narrowly.

PETER CONTI-BROWN: And that didn’t really work in the … in the Great Depression.

HELTMAN: This is Peter Conti-Brown.

CONTI-BROWN: I’m Peter Conti Brown, Assistant Professor at the Wharton School of the University of Pennsylvania, and non-resident fellow in economic studies at Brookings. Congress pretty quickly decided that it preferred other kinds of institutions to take on that primary role. So this is when the Reconstruction Finance Corporation, for example, was created in 1932, and which continued to the mid-1950s. And so this 13 … Section 13(3) lending, essentially atrophied. We didn’t see any of it between the 1930s and 2008.

HELTMAN: That’s not because we didn’t have recessions over that time — or because nobody asked for the Fed’s help.

CONTI-BROWN: We did definitely have recessions — you know, there’s three during the Eisenhower administration, for example, and each one carries little echoes of “Oh, is this going to be 1929 all over again.” There were other kinds of failures where you know, it, entities and institutions and individuals would go to the Fed and say, “Please, lend us money, we can’t get lending from any other entity.” So most famously was Penn Central Railroad that collapsed. They went to the Fed, and they were denied. Cities — New York had some really intense fiscal pressures of the 1970s. They went to the Fed and were denied. And so it was this seen as a kind of Rubicon.

HELTMAN: Part of the reason it wasn’t really used has to do with the way the Fed works. When the Fed steps in — for a bank or anyone else — it doesn’t just give money away. It offers a loan, and takes collateral to secure that loan. But the type of collateral the Fed was allowed to accept limited the potential scale of 13(3) lending for most of the 20thcentury.

SELGIN: The original collateral requirement was basically something called commercial paper —commercial IOUs. And these were short-term IOUs that were meant to finance ongoing production, anticipating receipts for sales of goods, that sort of thing. Banks routinely lent on commercial paper, so they usually had the stuff on hand — particularly banks that were in commercial areas. There were some banks in the countryside that didn’t have any commercial paper. They found themselves somewhat out of luck trying to get help from the Fed as a result, but many banks did have it. Other business firms seldom did.

HELTMAN: That changed in 1991 with the passage of the FDIC Improvement Act, which was designed to change some of the ways the FDIC worked in the wake of the Savings and Loan crisis of the 1980s. But it also changed the Fed’s collateral requirements for 13(3) emergency lending, effectively allowing the Fed to provide emergency liquidity in exchange for whatever collateral it thought was appropriate.

CONTI-BROWN: So 2008 was remarkable for so many reasons. But one was because we broke the glass on this authority, beginning in March 2008, when a broker-dealer — not unlike Robin Hood, frankly — much older, Bear Stearns was, you know, it was threatening to pull with it the rest of the financial system. And so that’s when the Bernanke fed authorized this unusual power. And it became, you know … 13(3) entered the more mainstream political lexicon as this kind of Federal Reserve bazooka, with a lot of financial and economic power behind it, but also a lot of political controversy associated with it, too.

KAREN PETROU: It’s the same conversation we’re going to have to have again, which is moral hazard.

HELTMAN: Could you tell us who you are, please? And don’t forget to plug your book.

PETROU: Thank you. My publicist is trying to inculcate that on me. I’m Karen Petrou, managing partner, Federal Financial analytics, and I’ve got a new book coming out, my first: Engine of Inequality, the Fed and the Future of Wealth in America.

HELTMAN: When the Fed broke the glass on 13(3) in the 2008 financial crisis, it was because many of the largest financial institutions were facing an almost unprecedented liquidity shortfall, all at the same time. Policymakers believed — with good reason — that letting those firms collapse would irreparably tank the entire global economy. Bailing those firms out because they were too big to fail was and remains unpopular, because it rewards the kind of excessive risk-taking that led to the crisis in the first place. But Petrou says it also sent a signal to the financial world that the Fed won’t let anything really bad happen to them.

PETROU: The Fed errs on thi e side of markets. I have a good deal in my book about this because I think this is one of the ways the Fed makes American inequality much worse, because it views its mission as market stabilization, not a shared prosperity. We see over and over again when the Fed fears market turmoil, which is of course not a good thing. But there’s a lot of difference between market turmoil and financial instability. And there is a good deal to be said in favor of market discipline as opposed to moral hazard. But the Fed is sufficiently frightened of more than a little bit of market instability, or of a giant financial companies failing, particularly in a disorderly fashion that it has historically 2008 and 2020 just thrown trillions into the market to keep them whole. If you want to ask, why is the stock market going up so much? And why are financial companies getting bigger and bigger and bigger? And why is the American economy more and more, quote-unquote, “financialized,” you have the Fed to thank for that.

HELTMAN: In response to those concerns about moral hazard, Congress changed the Fed’s 13(3) authority in the 2010 Dodd-Frank Act. But Congress didn’t just change 13(3) back to the way it was before.

KATE JUDGE: Part of what’s actually interesting about the Dodd Frank changes is what didn’t change, right?

HELTMAN: This is Kate Judge, a professor at Columbia Law School.

JUDGE: There were aspects of Dodd Frank that were targeted efforts to prevent the Fed from doing again — what it had done during 2007 and 2008. And as you point out, one of the most significant interventions that nobody wanted to see repeated, were efforts to save particular institutions. So the efforts to save Bear Stearns and the efforts to save AIG were seen as things we do not want to have happen again. And so they put in this this new requirement, broad-based eligibility.

HELTMAN: In Dodd-Frank, Congress attempted to navigate a course between two competing concerns: on the one hand, getting rid of 13(3) altogether takes an important tool away from the Fed that it might wish it had if another crisis comes along. But it also didn’t want to create a scenario where the Fed was picking winners and losers. What Dodd-Frank did was to modify 13(3) such that emergency lending could only be made available to a broad class of potential borrowers, with at least five potential applicants. There were other restrictions, too, but they were more cosmetic.

JUDGE: So for example, after Dodd Frank, rather than acting alone, the Fed has to act in consultation with Treasury and to get the Treasury Secretary’s approval for 13(3) facilities. In practice, this was something the Fed had long done.

HELTMAN: The coronavirus pandemic was the first time this new iteration of 13(3) actually got tested, and the Fed approached this crisis by establishing several different 13(3) credit facilities designed to backstop different credit markets, including municipal bonds, corporate bonds and ordinary businesses through the Main Street Lending Program. They actually did a similar thing in 2008, but this time those facilities played a much more central role.

JUDGE: When Congress came in, they didn’t say, “Okay, now we’re going to give the Treasury Secretary the authority to provide capital or to buy up assets as needed to keep the system functioning well.” Instead, this 13(3) authority is going to be the mechanism through which we’re actually going to try to inject additional support to businesses and to municipalities. And so it was a very different use of 13(3). The Fed had, early in March, rolled out a number of the facilities they had used in ’08, so they kind of took the playbook immediately put it to use. But [cut] the real change was that when Congress came in, instead of saying, “Treasury, we trust you, and we want you to solve this. And we’re going to give you real money, and you have a lot of discretion over how to use to do it,” they instead said, “We’re going to give money for the Fed and Treasury to work together. And then to create these 13(3) facilities.” But then, of course, there’s legal limitations on what the Fed can do under 13(3), and there’s real limitations in the amount of credit risk that the Treasury Department seemed willing to take on. And so and there were institutional limitations in terms of where the Fed could readily inject additional support into the system.

HELTMAN: One of those institutional limitations is that the Fed doesn’t take losses — in other words, it won’t make a loan that it thinks will lose money.

CONTI-BROWN: If I’m a banker, and I tell you, shareholders, “We have never lost money on a loan,” you would know that either I’m a liar, or I’m a terrible banker. That’s not a thing you’d want to brag about. Because that means that if you’ve never lost any money on a loan, that means that you’re not taking enough risk, you’re only choosing high-performing loans, which means that there’s these there are not going to be people where you’re going to be making much money on interest. The Fed’s different. It’s not like a private bank. But it really takes pride in the fact that it’s never taken a loss. I said, I describe that in such a way, because I think the Fed is making a mistake here, I think it should be prepared to take losses on individual loans so long as its general income is positive. Because that way, we will know that they are taking the they’re being appropriately aggressive in an emergency and taking the risk they need to take to make sure that credit availability is going where it needs to go.

SELGIN: When we come to the 2020 crisis, we have two different kinds of reactions. I’d say they let’s just get the money out of the door reaction is a good description of the paycheck Protection Program lending done by the SBA. And we all know that money was dispersed through that program to a lot of borrowers who probably shouldn’t have gotten it — there has been a lot of abuse. On the other hand, it was quick, and the money did go out. It was exhausted very quickly for the first round, and they had to renew the program. In contrast 13(3) lending to businesses, particularly the main street lending, that was not quick. First of all, it took the Fed and the Treasury together months to … to come up with what they thought would be a workable program that would satisfy the law on one hand, and get money to the targeted businesses on the other. It took them months — there’s nothing fast about it. And then the program they came up with, instead of being like a fire hose, was more like just a little trickle and … and it was very, very disappointing.

HELTMAN: We’ll talk a little more about how those lending facilities performed after this short break.

HELTMAN: Back in November, the Treasury Department sent a letter to the Fed terminating many of the emergency lending facilities. And part of the reason the Treasury Department gave for ending those programs, only a few months after they got up and running, was because they weren’t doing very much lending. And it’s true that many of the Fed’s 13(3) facilities ended up making rather modest investments in the pandemic. When the Main Street Lending Program closed at the end of last year, it had made a little over $16.5 billion in loans, while the Corporate Credit Facility to shore up corporate bonds had roughly $14 billion in loans outstanding and the Municipal Liquidity Facility had $6.3 billion in loans outstanding. The the Money Market Liquidity Facility peaked early in the pandemic, with about $50 billion lent, and the Commercial Paper Funding Facility at its peak lent out about $13 billion. Part of the reason those investments were so modest is because they perform a service just by being there — markets can often start to function again if they know the Fed can step in if things go wrong.

And since the Fed facilities helped the markets function normally, there were many other ways for businesses to get credit in the pandemic — especially the kinds of creditworthy borrowers who would be eligible for Fed loans. Just ask Kevin Handley.

KEVIN HANDLEY: Yeah, Kevin Hanley. I’m a regional senior lender with Enterprise Bank in St. Louis. I manage a couple of portfolios within the bank, from a credit perspective, really, it’s a … it’s a credit approval, functional role within the bank.

HELTMAN: He also oversaw Enterprise’s administration of Main Street Lending Program loans — all 11 of them. That doesn’t sound like a lot, and frankly it isn’t. But the reason more businesses didn’t use Main Street is because they found more attractive credit elsewhere.

HANDLEY: I think our preference, frankly, was to find a traditional solution on our balance sheet for our customers. And, you know, in some cases, because of the uncertainty around when their business would return to normal. That was a difficult credit discussion for us.

HELTMAN: But the Main Street facility also allowed Enterprise to extend credit to companies that weren’t already customers and whose needs couldn’t be met in-house.

HANDLEY: We did do some new deals with … with companies that weren’t borrowers, and I would say it was a similar situation where, yeah, we can’t tell you what it’s gonna look like for the next 12 to 18 months, but we did believe that there was longer term … the prospects for the company were such that we were willing to kind of take that … take that risk, and the program only has us retaining 5% of the loan, as you know, so in the case of the new borrowers that we did, they also had very uncertain prospects. But we believed in the business long-term such that, you know, we were comfortable making a loan. If you look at the composition of the 11 deals that we did, they were frankly, in industries that were extremely hard hit by the pandemic. We did some and travel services, hospitality, event management — we had several and event management. And we closed all of these, by the way, in December of ’20. And so as we were looking at fiscal, our calendar 2021, it was very difficult for these companies to project their financial performance for the next 12 months. So in that respect, I think it would be difficult under traditional means to get financing.

HELTMAN: So if the Main Street facility was helpful for borrowers who couldn’t get traditional loans —even if it wasn’t a large number of borrowers — what’s the harm in making those facilities available? The answer to that question is that it isn’t really the right question. In this case, the question isn’t whether borrowers should be able to get loans so much as whether the Fed should be the ones doing the lending.

SELGIN: The solution, as I see, it is very simple. If it’s a question of giving money to potentially insolvent outfits, then the Fed is the wrong vehicle. It should be considered not only a fiscal policy operation, but one that fiscal authorities and Congress should handle and leave the Fed out of. The Fed, of course, could be involved in an administrative capacity, it has certain advantages to offer in that regard. But it shouldn’t be a source of funds. Because the Federal Reserve constitution is such that the Fed is inclined — correctly — to use its own funding powers only to the extent that it can do so without incurring big losses. That’s in the DNA of the Fed. And that rules out risky lending for the most part. In contrast, if firms are going to be helped, that could end up failing, even with help, the Treasury and Congress should do that, and the Treasury should … and together, they should fork up the necessary money, borrowing for the purpose, not with the Fed’s help, not leveraging through the Fed.

HELTMAN: It sort of sounds like what you’re saying is that, like, 13(3) would be better if it was … if that same sort of mechanism was housed at Treasury than at the Fed.

SELGIN: Except that … Yes, yes. You could put it that way, John, it would be a lot more transparent. And it would it wouldn’t involve any magic money creation or levering up or anything, it would simply be, let’s say the Treasury says, “We’d like to see … we’d like to see loans made to businesses that aren’t covered by the paycheck Protection Program. We’d like to see $600 billion in lending to such businesses.” They hope the Fed would do that with a $75 billion backstop. Didn’t happen. Instead they lent $17 billion.

HELTMAN: But there is also a view that, while the Fed facilities — particularly the Main Street facility — weren’t particularly robust, they could be made more robust with some tinkering.

JUDGE: One of the open questions is, could the Fed actually do this in a more effective way? It was clear to me at least right at the beginning that the Fed was going to be able to be much more effective for the largest corporations and the smallest corporations. Whether it could have done more for small businesses remains deeply contested. One of the big questions is how much credit risk should they have taken or could they have taken and there are concerns that they were being … whether it was the Fed or Treasury that the overall terms of the Main Street facility were such that they were not manifesting that much willingness to take on credit risk. And if you think that the aim of the facility was to stop corporations from ending up in liquidation unnecessarily, and therefore allow those companies to continue to be part of a productive part of output, you know, creating productive capacity whenever we get past the pandemic, and help feed demand by continuing to feed employees, there’s reasons to think you might have wanted, you know, the Fed and Treasury collectively through this portfolio to take on more credit risk, and that the Treasury could have eaten that up with the money Congress specifically allocated in the CARES act. We know that the Fed, you know, that was clearly not the Fed sweet spot, it’s never going to be the Fed sweet spot, whether they might someday be able to do more there is currently unknown. And thanks to the Toomey amendment is not something we’re going to figure out in the short run.

HELTMAN: That amendment she’s referring to is an amendment to the December COVID relief package offered by Sen. Pat Toomey, a Republican from Pennsylvania, that would have barred the Fed from creating any new 13(3) facilities without the express consent of Congress. That amendment was later toned down to apply only to CARES Act funding, but the question of whether the Fed has too much power to lend beyond the banking system is still very much alive.

CONTI-BROWN: This is really controversial, and not just controversial in the ways that are that Senator Toomey has made controversial. It’s controversial because up until the very end of its life, the Main Street Lending Program, and to a less … slightly lesser extent the municipal lending facility did not have a lot of takeup. So, does that mean that they didn’t succeed well? Some people say that’s exactly what it means — the Fed should have done more to intervene so that it was easier for mainstream firms to get access to credit. Others will say no, this functions exactly as you’d want, because private lenders could go forward and that they wouldn’t be left holding every bag at the end of that cycle — that the Fed would be there. And because of that assurance, then, you know, the private markets, we’re able to function much, much better. So who’s right between that? Should you valuate the success of 33 facilities by the amount of lending was undertaken? Or do you evaluate the success of these facilities by the amount of lending was undertaken by private institutions? And I think that’s a really hard question to answer. It really depends on how, what you think about government participation in emergency lending, more generally.

HELTMAN: is this going somewhere? Or is this just kind of like an academic exercise of, like …

PETROU: I don’t know. That’s a great question. I know Senator Toomey wants to take it somewhere. And these these are issues I think in which, if they want to, he and Senator Brown could genuinely agree. Because neither of them believes in moral hazard and market rescues. Senator Toomey doesn’t believe in them because he believes in market discipline and quote, “the free market,” red in tooth and claw, and Senator Brown doesn’t believe in them because he doesn’t think financiers deserve deserve safety nets. But the basic point they both won is a Federal Reserve that does not provide the ongoing promise of never ending market stability. That kind of a promise is the platform from which we’ve seen enormous speculation.

HELTMAN: Deciding how much power the Fed should have to lend in an emergency has hazards on both sides. If the Fed’s power to lend is too narrow, it doesn’t lend and crises bring down businesses that would otherwise be healthy and productive. And if the Fed’s power is too broad, it creates the impression in markets that the Fed can catch you no matter how far you fall. Dodd-Frank attempted to navigate those hazards, but as we learned in 2020, it wasn’t entirely successful.

PETROU: After Dodd Frank, when Congress said, in law, “We really don’t want you to keep stepping in and rescuing giant financial companies. But we’ll give you some authority to at least rescue the financial system. But we really don’t want you to use it.” And the Fed opposed that provision. Janet Yellen and Bernanke — to this day — have said they wish it wasn’t in Dodd-Frank. And they have been extraordinarily reluctant to pass the rules mandated by the law to recognize Congress’s instructions, just last year, in the CARES act, to use these facilities sparingly because the Fed wants to be in charge of the financial system. And that’s the fundamental thing. I think that’s wrong. You can understand why a central bank wants and needs significant tools, but it’s supposed to exercise those for monetary policy. And it’s not just backstopping the market — the Fed hasbecomethe market, because everyone expects it always to intervene. Little bitty losses, day in day out, come and go. But if anything really bad looks possible, the markets are so confident the simple step in and stabilize them, whether it’s through monetary policy with ultra-low rates that create more appetite for equity investors, or through new facilities.

CONTI-BROWN: It would be more useful for us to understand under what circumstances will we see non-bank, non-financial lending in a crisis. Well, the Fed would like to say is, “Let’s not offer any clarity right now, because we want to maximize freedom of movement.” I think that’s pretty problematic. I think it’s problematic because we need to have some sort of clarity. Otherwise, the moral hazard problems become real. You mentioned that, you know, in a pandemic, where’s the moral hazard? And the answer is in preparation for downturn. So the pandemic is … you can’t anticipate that we’re going to have, you know, for novel Coronavirus is one that takes root and then as they continue to mutate, grinding things to a halt, but preparation for exogenous shocks is not all or nothing. And if the expectation is that the Fed will be there to do everything that it can, whatever it takes, to keep the economy singing along, so the kinds of private preparations that you’d want to see for an exogenous shock will slip away. And that’s not good. It really is about socializing costs, while privatizing benefits.

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