Greater Opportunity Through Innovative Change


By: Greg Kaza

The central bank has emerged as the lender of last resort in time of potential financial crisis.

The Federal Reserve, in responding to last week's terrorist attacks on the World Trade Center and Pentagon, fulfilled its function as the lender of last resort to the U.S. financial system. "The Federal Reserve is open and operating," a statement released the day of the attack (Sept. 11) read. "The discount window is available to meet liquidity needs."

The Fed followed the action by cutting a key interest rate, the intended fed funds rate, from 3.5 to three percent, a 50-basis point reduction. The action occurred on the day U.S. stock markets reopened.

The terrorists killed more than 5,000 innocent civilians, injured thousands and attacked symbols of America's military might and free enterprise system. With the economy already in recession and consumer confidence uncertain, the Fed signaled its intention to make available "liquidity," or cash, to meet the demands of individuals and businesses served by U.S. financial institutions.

Public understanding of the Fed's action is important given uncertainty in financial markets. The intended fed funds rate was 6.5 percent in January when the Fed started easing monetary policy to stimulate the U.S. economy. The Fed has cut fed funds eight times this year, a reduction of 350 basis points.

Fed funds is the intended rate at which banks seeking additional reserves borrow short-term from those with excess capital. The discount rate, largely symbolic by contrast, is the rate the Fed charges banks for borrowing funds.

Before the attack we forecast the Fed would cut inteded fed funds to at least 2 percent, 100 basis points lower than the consensus among economists. A lower fed funds rate is now possible given economic fundamentals.

The Fed's action following the terrorist attack was part of a massive coordinated easing of nearly $120 billion by the world's largest central banks, including the European Central Bank and Bank of Japan. Private corporations also played a role, pledging to repurchase their stock to boost consumer confidence.

Although largely ignored today, private corporations and large investors assumed the role of lender of last resort prior to the Fed's creation in 1913. Financier J.P. Morgan, brought order to markets in the Panic of 1907, precipitated by a crisis in trust companies linked to commercial banks through investment banking.

Morgan took command of a group of bankers who provided liquidity to end the crisis.

The idea central banks should serve as a lender of last resort originated with 19th Century British economists. The Bank of England explains lender of last resort means "the discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank."

Central bank action occurs "in reaction to an adverse shock," such as a terrorist attack, war or sharp spike in oil prices, "which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source." The function is meant to serve as a safety net for fractional reserve banking systems such as those in the West that permit financial institutions to hold reserves of less than 100 percent against their deposits.

Economist editor Walter Bagehot and British Treasury official R.G. Hawtrey developed the idea. Mr. Bagehot (1873) suggested the central bank, in a liquidity crisis, should lend freely at a higher rate of interest to creditworthy borrowers. Financial institutions without good collateral, he maintained, should be permitted to fail. Mr. Hawtrey saw the central bank serving as "a stabilizing force" in crisis.

There are no bank runs today and the Fed's actions were meant to prevent panic. Indeed, some believe that Fed Chairman Alan Greenspan's finest hour occurred in the wake of the October 1987 stock market crash. Responding to the Dow's 22 percent decline in one day, Mr. Greenspan announced, "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."

Economics is a profession prone to complexity yet Mr. Greenspan's one-sentence statement prevented a panic. Many are now hoping these actions accomplish a similar goal.

Greg Kaza is executive director of the Arkansas Policy Foundation.