Emergency lending facilities

The LINK_POOL table is constructed as follows:

The external links are:

1. Federal Reserve Act, Section 13(3) citation: https://www.federalreserve.gov/aboutthefed/section13.htm (Federal Reserve Board)
2. ECB Emergency Liquidity Assistance (ELA) framework: https://www.ecb.europa.eu/mopo/liq/html/index.en.html (European Central Bank)
3. Dodd-Frank Act: https://www.sec.gov/news/press-release/2010/2010-138.htm (U.S. Securities and Exchange Commission)
4. Moral Hazard in LOLR: https://cepr.org/voxeu/columns/confusion-about-lender-last-resort (Centre for Economic Policy Research - VoxEU)

What Is Emergency Lending Facilities?

Emergency lending facilities are temporary programs established by central banks to provide liquidity to financial markets and institutions during times of severe financial stress or crises. These facilities fall under the broader category of monetary policy tools, specifically as part of the central bank's role as a lender of last resort. Their primary purpose is to prevent widespread financial disruption and ensure the continued flow of credit in the economy when traditional funding channels become impaired. Emergency lending facilities extend credit beyond typical operations, often to a wider range of financial institutions or even non-financial entities, to stabilize the banking system and the broader economy.

History and Origin

The concept of a central bank acting as a lender of last resort, providing emergency liquidity, dates back centuries. However, the formal establishment and widespread use of broad emergency lending facilities as seen today largely evolved from major financial crises of the 20th and 21st centuries. In the United States, for instance, the Federal Reserve's authority to undertake such actions is rooted in Section 13(3) of the Federal Reserve Act, a provision added during the Great Depression through the Emergency Relief and Construction Act of 1932.²⁷ This section permits the Federal Reserve to make loans to individuals, partnerships, and corporations in "unusual and exigent" circumstances.²⁶

During the 2007-2009 financial crisis, the Federal Reserve extensively used its Section 13(3) authority to establish various emergency lending facilities, extending credit to nonbank financial firms for the first time since the 1930s.²⁵ These included programs like the Term Asset-Backed Securities Loan Facility (TALF), which supported the issuance of asset-backed securities, and facilities to provide liquidity to primary dealers and the commercial paper market.²⁴ Similarly, the European Central Bank (ECB) provides Emergency Liquidity Assistance (ELA) to solvent financial institutions facing temporary liquidity problems, an operation distinct from normal monetary policy and governed by specific rules and procedures.²², ²³ The framework for such assistance by the ECB emphasizes the responsibilities, costs, and risks borne by national central banks while ensuring that ELA operations do not interfere with the single monetary policy of the Eurosystem.²¹

The significant expansion of emergency lending facilities during the 2007-2009 crisis led to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.²⁰ This legislation curtailed the Fed's Section 13(3) lending authority, requiring that future emergency lending serve a broad sector, effectively preventing assistance to specific firms and mandating Treasury Secretary approval for such actions.¹⁹ Despite these changes, central banks globally continue to adapt and deploy emergency lending facilities in response to new challenges, as evidenced by the widespread use of such facilities during the COVID-19 pandemic.¹⁸

Key Takeaways

• Emergency lending facilities are temporary liquidity programs deployed by central banks during financial crises.
• They aim to stabilize financial markets and ensure the flow of credit when normal channels are disrupted.
• These facilities extend credit beyond typical central bank operations, often to a broader range of entities.
• Central banks act as a "lender of last resort" through these facilities to prevent systemic collapse.
• The terms and conditions for emergency lending facilities are often more flexible than standard lending.

Interpreting the Emergency Lending Facilities

Emergency lending facilities are a critical tool in the macroprudential toolkit of central banks. Their existence and activation signal significant stress in the financial system. The scale and scope of these facilities, including the types of assets accepted as collateral and the duration of the short-term loans, provide insights into the central bank's assessment of the severity and nature of the crisis. For instance, the establishment of facilities targeting specific markets, such as the commercial paper market or municipal bonds, indicates distress in those particular segments.¹⁶, ¹⁷ The terms of these facilities, including interest rates and fees, are often set to encourage repayment as market conditions improve while providing necessary relief during the crisis.

Hypothetical Example

Imagine a sudden, unexpected global event causes a severe and rapid loss of confidence across financial markets. Banks become highly reluctant to lend to each other, and companies struggle to obtain necessary short-term funding. In this scenario, the interbank lending market seizes up, threatening to cause a cascade of defaults.

A major central bank might respond by activating an emergency lending facility, perhaps called the "Temporary Liquidity Support Program." Under this program, eligible financial institutions, including commercial banks and certain investment firms, could borrow funds directly from the central bank against a wider range of collateral than typically accepted in normal operations. For example, a bank needing immediate cash might pledge corporate bonds or even highly-rated mortgage-backed securities as collateral to receive a short-term loan. This injection of liquidity from the central bank helps prevent the bank from defaulting on its obligations, which could otherwise trigger a broader systemic risk across the financial system. By providing this lifeline, the central bank aims to restore confidence and unfreeze credit markets.

Practical Applications

Emergency lending facilities are primarily deployed by central banks during periods of financial instability to address severe liquidity shortages and prevent systemic contagion. Their applications include:

• Stabilizing Interbank Markets: When banks become distrustful of each other's solvency, the interbank lending market can freeze. Facilities like the Primary Dealer Credit Facility (PDCF) provide direct liquidity to key financial intermediaries, ensuring the flow of funds.¹⁵
• Supporting Specific Credit Markets: During crises, particular credit markets, such as those for commercial paper or asset-backed securities, can become illiquid. Emergency facilities, such as the Commercial Paper Funding Facility (CPFF) or the Term Asset-Backed Securities Loan Facility (TALF), are designed to unfreeze these markets.¹³, ¹⁴
• Ensuring Business and Household Credit: Beyond financial institutions, some emergency lending facilities, like the Main Street Lending Program during the COVID-19 pandemic, were designed to provide credit directly to small and medium-sized businesses and non-profits, or to support programs like the Paycheck Protection Program.¹¹, ¹²
• International Liquidity Provision: Central banks also establish swap lines with foreign central banks to provide U.S. dollar liquidity, addressing global funding shortages.¹⁰

For a detailed overview of various facilities established by the Federal Reserve in response to recent crises, the Federal Reserve Board provides information on its funding, credit, liquidity, and loan facilities.

Limitations and Criticisms

While essential for crisis management, emergency lending facilities face several limitations and criticisms:

• Moral Hazard: A significant concern is the potential for moral hazard. If financial institutions expect a central bank bailout during times of stress, they might engage in excessive risk-taking, knowing they have a safety net.⁹ Critics argue this can incentivize reckless lending and investment practices.⁸ However, some research suggests that central banks, when acting as a lender of last resort, have prudently applied their frameworks and have not incurred financial losses, mitigating some moral hazard concerns.⁷
• Stigma: Borrowing from emergency facilities can carry a "stigma," signaling to markets that an institution is in distress. This can deter banks from using the facilities, even when they need liquidity, undermining their effectiveness.⁶
• Scope and Authority: The legal authority and scope of emergency lending facilities can be debated. Legislation like the Dodd-Frank Act has sought to refine and limit the Federal Reserve's Section 13(3) authority, requiring that assistance be broad-based rather than firm-specific.⁵
• Impact on Central Bank Balance Sheet: Large-scale emergency lending operations can significantly expand a central bank's balance sheet, potentially raising concerns about future inflation or the central bank's independence, though such operations are often sterilized to control liquidity.⁴
• Fairness and Distribution: The design of emergency lending facilities can lead to questions about fairness, particularly concerning which institutions or sectors receive support and the terms of that support.

Emergency Lending Facilities vs. Quantitative Easing

While both emergency lending facilities and quantitative easing (QE) are central bank tools designed to influence the economy, they differ in their primary objectives and mechanisms.

Emergency lending facilities are a crisis-response measure aimed at alleviating immediate liquidity shortages and preventing financial contagion. QE, on the other hand, is a broader monetary policy tool intended to provide ongoing economic stimulus.

FAQs

Why do central banks create emergency lending facilities?

Central banks establish emergency lending facilities to inject liquidity into financial markets and institutions during times of severe stress. Their goal is to prevent a financial crisis from spiraling out of control, ensuring that businesses and households can still access credit even when normal funding channels are disrupted.

Are emergency lending facilities the same as bailouts?

While emergency lending facilities provide financial support, they are generally distinct from traditional "bailouts." Emergency lending typically involves providing loans against collateral, with the expectation of repayment.³ Bailouts, in common usage, often refer to direct government injections of capital or guarantees that might not be fully repaid. The intent of emergency lending facilities is to address temporary liquidity problems, not solvency issues, although the line can become blurred during severe crises.

What is the role of the U.S. Treasury in emergency lending facilities?

In the U.S., under Section 13(3) of the Federal Reserve Act, the U.S. Treasury Secretary must approve the establishment of any emergency lending facilities.² The Treasury may also provide backstop funding or credit protection for these facilities, absorbing some of the potential risk for taxpayers.¹

How do emergency lending facilities affect the broader economy?

By providing essential liquidity, emergency lending facilities aim to stabilize the financial system, prevent a credit crunch, and ensure that businesses can continue to operate and consumers can access loans. This helps to cushion the economic impact of a crisis and supports overall economic stability and employment.