Lender of Last Resort
...introduced long run changes like the SEC act, deposit insurance and the formation of the FDIC. It also ultimately resulted in the Banking act of 1933 which resulted in Regulation Q and separated commercial banking from investment banking and curtailed bank activity in the insurance and securities market. This went a long way in helping the Fed maintain financial stability. The Credit crunch of 1966 also aided in the development of the lender of last resort function in the United States economy. The credit crunch of 1966 was bought about by accelerating inflation and the fact that the Fed began to fear inflation and tightened monetary policy to the point that the profitability of financial institutions was threatened. In 1966 there was a vast reduction in the credit that was available. This can be seen in the flow of funds in the third and fourth quarter of1996. The credit crunch of ’66 resulted in a contagion among nominal interest rates above the price ceiling set by Regulation Q which almost led to system wide disintermediation and as a result of the intervention of the Fed new financial practices emerged and were validated. Also the Penn Railroad crisis resulted in the creation of lines of credits for banking institutions. Thus the lender of last resort function has developed as various economic upheavals have resulted in Fed intervention and the implementation of new policy. There are several policy instruments that the fed can use to provide liquidity when the lender of last resort function is necessary. Monetary strategy is composed of Goal priorities including risk containment and is enacted in order to make the fed transparent and credible. Goal priorities must be linked to the Feds target and the target is what the Fed tries to achieve through its policies. When there is a crisis in the economy, providing liquidity and acting as a lender of last resort takes precedents over all other goal and becomes the major priority of the Fed. Thus when the Fed is acting as a lender of last resort, providing liquidity and maintaining financial stability is its one and only goal / target at that time. The main policy instruments that the central bank can use as a lender of last resort is .the discount rate and however open Market Operations and the reserve strategy are two other policy instruments. The Discount Rate is another policy tool that can be used by the central bank under the lender of last resort function. The discount rate is the rate the Fed charges for loans to depository institutions. A reduction in the discount rate would make banks more willing to use the discount window than sell short term securities. As a result, there is more liquidity in the market and this can offset a crisis. Changes in discount window policy occur when the fed needs to provide liquidity. For example, Following September 11, the Fed encouraged depository institutions needing liquidity to borrow from the discount widow and Reserve Banks lent $45.5 billion to depository institutions on September 12 and this was a record high. Open market operations are a very important policy instrument because each purchase or sale of bonds directly affects the volume of reserves in the banking system. Hence when a central bank is acting as a lender of last resort and needs to provide liquidity very quickly, open market operations can be quickly and easily used to do so. Purchases of bonds increase reserves and provide credit because the Fed pays for the purchase of securities by crediting the reserve account of the bank they are buying from. According to the FRBR website, “Operations are either dynamic or defensive.” Dynamic operations either increase or decrease the volume of reserves in order to ease or tighten credit. Thus a central bank would want to increase the amount of reserves in order to provide liquidity and ease the crisis. Another strategy that a central bank can use when it is acting as a lender of last result is changing reserve requirements. Reserve requirements are the percentage of deposits that depository institutions must hold as reserves. This can provide liquidity in a crisis because a reduction in reserve requirements increases excess reserves and stimulates the economy and provides liquidity. Although reserve requirements are a powerful tool, Reserve requirements are seldom changed in the conduct of monetary policy because they are more disruptive than open market operations. There are two profound examples of the fed acting as the lender of last resort in recent times. These two examples are the stock market crash of 1987, the so called “Terrible Tuesday when trading all but stopped on the stock market and the crisis the economy faced during the events of September 11 2001. On Tuesday the 19th of October 1987 the United States economy faced its worst crisis since the crash of 1929. Stock trading, options trading and futures trading all but stopped for a crucial interval. The Dow Jones industrial average had fallen by about 500 points on Monday and in the wake of this big board specialists whose responsibility it was to buy and sell assigned stocks during volatile times all but exhausted their capital buying stock. In order to finance this borrowing they would have to borrow from financial institutions. Credit from banks is the sustenance of Wall Street securities firms and by Tuesday morning securities firms has swollen stock inventories and a high demand for credit. This high demand for credit was also fuelled by and explosion of trading in the government securities market. Thus Wall Street was facing an acute and drastic credit street the problem that the fed faced as a lender of last resort in this situation is that they needed to provide credit by providing liquidity. It was necessary for the Fed to counteract this credit squeeze because if credit dried up securities firm would start to collapse and contagion would spread in the market much like disintermediation spread during the crash of 1929. The feds second major purpose is to provide financial stability and if this had occurred even very simple financial transactions would have become impossible. 1987 was a change away from the direction the Fed was going by trying to tighten the economy and drive down accelerating inflation. Allan Greenspan temporarily suspended the tightening grip the fed had on the economy. This is not surprising because when a central bank has to act as a lender of last resort this function takes precedence over all other goals. The fed provided liquidity during the crisis of 1987 by using the borrowed reserve strategy. The fed increased the pressure on the degree at which banks were forced into the discount window and this increase in pressure resulted in banks borrowing heavily from the discount window. This is evidenced by the fact that during the month of October M1, one of the biggest m indicators accelerated drastically and this reflects the huge increase in financial transactions associated with the market turmoil. The Fed acted as the ultimate supplier of funds and flooded the banking system with money by buying government securities and quickly driving down short term interest rates. The fed also made it clear to banks they had opened the discount window which increased the pressure on banks ...