Vice Chair Stanley Fischer Discusses the Function of the Federal Reserve as Lender of Last Resort

Board of Governors of the Federal Reserve System (the “Fed”) Vice Chair Stanley Fischer reviewed recent changes in regulation and supervision concerning the role of the Fed as “lender of last resort.” In remarks before the Committee on Capital Markets Regulation delivered in Washington, D.C., he outlined post-Dodd-Frank Act developments, including: (i) lending to insured depository institutions and discount window loans, (ii) the shadow banking system and the Federal Reserve’s broad-based emergency facilities, and (iii) the Federal Reserve’s preventative measures for lending to individual non-bank institutions.

Vice Chair Fischer highlighted the following “three major sources of concern about potential weaknesses in the new framework for financial crisis management”:

  • The Dodd-Frank requirement that the Fed publish information about discount window loans has exposed banks to the stigma of borrowing from the central bank. This requirement prevents the discount window from functioning properly as a backstop to ensure liquidity, since banks fear that accessing the discount window will signal weakness to investors.
  • The general failure to maintain regulatory flexibility makes it difficult to address unanticipated events that fall outside the framework established by Dodd-Frank. On this point, Vice Chair Fischer noted that the Fed’s broadbased emergency credit facilities were instrumental in providing flexibility as the financial crisis unfolded.
  • The lack of flexibility (above) is exacerbated by the fact that the new financial system has not undergone a stress test of its own. Vice Chair Fischer emphasized that this source of concern “is, in one sense, fortunate, for the financial system will undergo its fundamental stress test only when we have to deal with the next potential financial crisis.”

Vice Chair Fischer noted that Dodd-Frank reduced the probability that the lender of last-resort functions will be needed in the future. However, he expressed concern that the moral hazard should not eliminate the capacity of authorities to respond to unanticipated events or crises, and “[s]trengthening fire prevention regulations does not mean that the fire brigade should be disbanded.”

Lofchie Comment: As Vice Chair Fischer notes, banks (very correctly) dread showing any “signs of weakness.” In the aftermath of Dodd-Frank, there was a sudden burst of enthusiasm for “transparency” and “fuller disclosure,” as if absolute truth were a panacea. It is not. The opposite is sometimes true: too much disclosure of problems at a bank potentially can trigger a run on that bank (and a run on one bank may spread to others). Warning against the dangers of too much disclosure is not an argument for dishonesty. Rather it is just an acknowledgement that too much candor can be a two-edged sword. (This is a problem that regulators have acknowledged in connection with money market funds: the risk that sophisticated investors can quickly flee, leaving smaller and less-informed investors behind.)

Further, it is good of the Vice Chair to acknowledge that many of the supposed benefits that are derived from Dodd-Frank are untested. For that reason, it is inappropriate for regulators to constantly assert how much “safer” the system has become. At best, they might say that certain numbers have moved in a positive direction. Of course, other numbers have moved in a negative direction. For example, the numbers now point to more volatility in the market, fewer clearing firms and greater centralization of risk.

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