The danger of the Federal Reserve being out of “options” to boost the economy has been a recurring theme of commentators and scholars in the years during and after the Fed’s extended use of quantitative easing and low interest rates. The Fed began raising interest rates in December 2015 and is now hinting that another hike will come soon.
But I propose that the Fed still has options it has not explored. There are three additional options for consideration that could help the Fed achieve its dual mandate and accelerate growth, each having to do with liquidity support that could be provided to banks through the discount window.
The discount window was originally conceived as the Fed’s fundamental way to regulate the flow of credit available in the banking system. It became more of a safety valve for banks with temporary funding shortages. Banks can obtain discount window credit in the form of discounts and advances. With advances, banks pledge securities and loans as collateral. In a discount, the Fed purchases a loan from a bank at a discount price; later, when the loan matures and the bank is paid then the bank repays the Fed in full.
Only certain types of bank assets are eligible for discounts or advances. Eligibility rules have continued to evolve over the years. Discount window advances were widely used when the discount rate was less than the federal funds rate, but since the 1980s, using the discount window has had a stigma associated with it. Even if a bank has been under pressure, it has been hesitant to tap the window because of the risk of announcing to the world that it is having difficulties.
Here are three additional liquidity-strengthening options.
Contingent liquidity facility
To make greater use of the discount window under current rules, William Nelson of The Clearing House recently proposed that the Fed set up a “Fee Based Contingent Liquidity Facility” to recognize the capacity of banks to borrow through the discount window as a “high-quality liquid asset.” This would free up funds for loans to businesses and industries that banks are currently diverting to other purposes to obtain HQLAs in order to satisfy regulatory mandates.
The facility would work as follows: In order to recognize the potential discount window borrowing ability of the banks, the Fed would establish, on demand, a contingency funding account for a bank and “advance into that fund, as discount window borrowing,” half the value of the assets pledged as collateral. That amount would then count toward their HQLA requirement under the Liquidity Coverage Ratio (LCR) regulations. Banks could thereby shift a portion of what they usually put into “deposits at the Fed, government securities, and securities issued by government supported entities” for meeting their HQLA requirement into loans to businesses and households.
But just how much more credit would banks be able to extend to the nonfinancial sectors of the economy? Nelson estimates an increase of over $1.1 trillion, or 15%, raising GDP by up to 0.75%. Banks would be permitted to meet a quarter of their HQLA requirement through the facility; that is $800 billion less HQLA the banks would need to obtain by buying government securities.
Expanding Fed liquidity support to longer-term business loans
A more ambitious method to increase loans to businesses and industries is to modify the type and maturity of assets acceptable for discounts at the discount window to include long-term loans to business and industry. This is a discounting power not utilized since the 1950s that could be revived and redesigned for today’s circumstances.
The original restrictions on the types of assets the Fed could discount contributed to the failures of banks in the 1930s and deepening the effects of the Great Depression. Beginning in 1932, Congress took aim at liberalizing what types of assets the Fed could discount for banks to unfreeze the banking system and speed the recovery.
In 1934, a shortage of working-capital loans being made to businesses and industries prompted Congress to give the Fed the ability to discount, purchase or make advances on business loans of up to a five-year maturity for banks, to make joint loans with banks and even to directly lend to industries themselves. Congress gave the Reconstruction Finance Corp. similar powers. But the RFC was closed in 1957 and the industrial lending powers of the Fed were repealed in 1958.
I am not proposing allowing the Fed to make direct loans to businesses, which would not find favor today, but a more modest revival of its power to discount these types of loans should be considered. A Fed backstop of this kind for banks could trigger more business and industrial loans, spurring long-term growth and creating more dependable and high-paying jobs. Congress would have to authorize it since the Fed cannot currently discount long-term loans made to businesses and industries, only 90-day commercial paper.
Given the unconventional monetary policy and historic financial legislation of the last decade, this discounting option is not so radical. To put it in context, the Fed could decide to simply take these loans onto its balance sheet like it did for other types of debt under its quantitative-easing policy.
Federal Reserve Loan guarantee program for banks
A third option is for the Fed to establish a facility to provide loan guarantees for banks based on the central bank’s surplus.
During World War II, the Fed served as agent to the government and guaranteed loans made by banks and other lending institutions for financing contracts. By 1946, the Fed had handled nearly 9,000 guarantees of war production loans, worth a total of over $10 billion. The interest and fees collected on this total not only covered program expenses and losses but yielded a profit.
After the government war guarantee program ended, some proposals were made for the Fed itself to make loan guarantees for banks and financing institutions on business loans of maturities up to 10 years, limited to the Fed’s surplus. The Fed supported the plan but it was not approved; however, a government loan guarantee program under President Eisenhower continued to utilize the Fed with regard to defense contracts (one wonders whether an infrastructure plan under President Trump could benefit from a non-defense version of Eisenhower’s program).
There are many government agency loan guarantee programs today, including the Small Business Administration’s 7(a) loan guarantee program.
But Fed loan guarantees for businesses and industries may be more efficient than those made through other government agencies, since the central bank may be more attuned to loan demand. It is worth exploring whether the Fed’s surplus could be safely used to encourage banks to increase their loans to business and industry with guarantees.
Discount window proposals like those described above could help shape economic growth and are worth consideration.