Frederic S Mishkin: Financial instability and the Federal Reserve as a
liquidity provider
Remarks by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Museum of American Finance Commemoration of the Panic of 1907,
New York, 26 October 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
In my remarks today I would like to address the issue of financial instability from two
perspectives: First, I will offer a conceptual framework that helps us understand why periods
of financial instability arise, and second, I will describe how the Federal Reserve has used
the provision of liquidity to reduce the damage to the economy during such periods of
turmoil.1
The interest of the Federal Reserve in financial stability does not arise out of a concern for
the functioning of financial markets as such or out of a desire to aid distressed investors or
institutions. Rather, the Federal Reserve vigorously promotes financial stability because of
the intimate connection between a stable financial system and solid macroeconomic
performance. The financial system, comprising financial markets and institutions, channels
funds to those individuals or firms that have productive investment opportunities. The better
the financial system performs this role, the more efficiently credit flows from lenders to
borrowers and the more efficiently the economy operates. A period of financial instability
arises when a shock to the financial system prevents it from channeling funds efficiently to
productive uses; as I will describe, such a shock generally relates to problems in the flow of
information. Unless checked, such a seizing-up of the financial system can lead to a
precipitous drop in lending and a steep decline in economic activity. Therefore, a stable
financial system is of vital importance for the Federal Reserve if it is to pursue its statutory
goals of maximum sustainable employment and stable prices.
Asymmetric information and financial instability
We can better understand how financial instability can arise if we recognize the problem of
asymmetric information - when one party to a financial contract has much less information
than the other party. For example, the borrower is usually much better informed than the
lender concerning the potential risks and returns associated with the investment projects to
be financed by a loan. Asymmetric information leads to two basic problems: adverse
selection and moral hazard. Generally speaking, adverse selection arises when investments
that are most likely to produce an adverse outcome are the most likely to be selected. For
example, investors who intend to take on large amounts of risk are the most likely to be
willing to seek financing. When the problem of asymmetric information is particularly severe
in the marketplace, lenders may decide to cut back on lending even though good credit risks
exist.2 Clearly, minimizing adverse selection requires that lenders screen out bad credit risks.
Moral hazard occurs when the lender is subjected to the hazard in which the borrower has an
incentive to engage in activities that are undesirable from the lender's point of view, that is,
activities that make it less likely that the loan will be repaid. For example, a borrower may
have an incentive to invest in high-risk projects in which the borrower does well if the project
succeeds but the lender bears most of the loss if the project fails. Again, if this conflict of
interest between the borrower and lender becomes particularly pronounced in the
marketplace, many lenders might decide that they would rather not make loans, which leads
to suboptimal lending and investment. To minimize moral hazard, lenders must impose
restrictions (known as restrictive covenants) that penalize borrowers for engaging in certain
activities; lenders must monitor those activities, and they must enforce the restrictions if the
borrower violates them.
Over time, the financial system has developed a variety of mechanisms to deal with
informational asymmetries. These mechanisms include a strong network of financial
intermediaries, sound and resilient financial markets, innovative financial products that
spread risk to the investors most willing and able to bear it, and effective supervisory and
regulatory frameworks. However, even the strongest financial system is not immune to
shocks. When such shocks interfere materially with information flows, the problems of
adverse selection and moral hazard can overwhelm the mechanisms intended to control
them. As lenders pull back and liquidity becomes scarce, a period of financial instability can
ensue, carrying with it, as I mentioned at the outset, the threat of a serious decline in
economic activity through a virtual cessation of lending.
Broadly speaking, at least four types of shocks can lead to financial instability. The first type,
and the one that has been the catalyst of many past crises, is a sharp increase in interest
rates. Higher interest rates increase the likelihood that borrowers will be poor credit risks
because those taking on more risk are the most willing to pay the higher rates; not
surprisingly, lenders have many times responded to sharp increases in interest rates by
cutting back the supply of loans, which results in credit rationing.
The other types of shocks are a sudden increase in uncertainty, a deterioration of corporate
and household balance sheets, and weakened financial intermediaries. Some of these have
clearly manifested themselves in the episode that has affected global financial markets in
recent months. In general, an increase in uncertainty makes it harder to obtain information
about borrowers, thereby deterring lending, and may arise from the failure of a large financial
institution, a market crash, a recession, or, as in the latest episode, an inability to value
complex financial products. Weak borrower balance sheets are also a deterrent to lending
because they worsen credit risk and thus make the problems of adverse selection and moral
hazard more prominent. The harmful effects of balance sheet deterioration were evident in
recent months, when concerns about borrower financial positions caused lenders to demand
a substantial premium on loans and even to drastically cut the flow of credit. Finally,
problems in the banking sector may also be a catalyst for financial instability because
financial intermediaries that find themselves with weakened financial positions typically
respond by cutting their lending.
A central bank can respond to an episode of financial instability by temporarily providing the
liquidity that financial intermediaries are unwilling or unable to supply. Central banks typically
inject liquidity into the system via the banking sector, but the intent is clearly to have the
liquidity spread from there. From banks, liquidity typically finds its way to financial markets
and to nonbank institutions that are unable to access securities markets. Thus, injections of
liquidity have the potential to directly address the causes of financial instability and therefore
to counteract the pernicious effects of financial instability on broad macroeconomic
conditions. With this understanding, we can now turn to some history.
The panic of 1907 and the creation of the Federal Reserve
During the National Banking Era, which began in 1865 and ended in 1914, when the Federal
Reserve began operations, reserves were channeled to New York banks, which became
providers of liquidity to the financial system through the New York Clearinghouse.
Nevertheless, the banking system periodically suffered panics, as the demand for liquidity
often exceeded what New York institutions could provide. These panics, in turn, caused large
numbers of banks to fail or at least suspend the conversion of deposits into currency. During
these episodes, interest rates tended to spike and equity markets to decline, often sharply.3
The Panic of 1907, the subject of this conference, was the last panic of the National Banking
Era and one of the most severe. During the summer of 1907, U.S. financial institutions,
especially those in New York, came under increasing pressure as interest rates crept up and
U.S. gold reserves declined; those movements were due in part to increases in interest rates
abroad as foreign central banks sought to maintain their gold reserves.4 The panic started in
October with a run on the Knickerbocker Trust Company, one of the largest financial
institutions at the time. The stock market crashed, and the resulting surge in demand for
liquid assets by banks that had New York correspondents, as well as by the general public,
caused a sharp rise in interest rates, the failure of a number of financial institutions, and
widespread suspensions of convertibility of deposits into currency. The subsequent banking
crisis arguably turned a mild recession into a sharp, though fairly short, contraction.
As a result of the 1907 crisis, the Congress set up the National Monetary Commission to
consider whether the federal government should more actively manage the nation's money
supply. The committee's recommendations led to the creation of the Federal Reserve. Thus,
an important impetus for the establishment of the U.S. central bank was the desire to prevent
panics such as the one in 1907, whose detrimental effects on the rest of the economy were
not lost on policymakers.5
At the time, the belief was widespread that the inelasticity of the currency contributed to the
weakness of the financial system. The supply of high-powered money - which included
national bank notes, specie, U.S. notes, and silver certificates - was relatively fixed
(inelastic) in the short run. Thus, even fairly moderate increases in demand for high-powered
money led to higher interest rates. In addition, some of the increases in the demand for
money were not random; they were associated with the crop cycle and were thus seasonal.6
Just as no existing mechanism or institution could quickly supply the liquidity needed to
respond to a rise in the demand for money, none could supply it to resolve the ensuing crisis.
The establishment of the Federal Reserve provided the nation with an institution that was
able to expand the money supply to virtually eliminate seasonal fluctuations in interest rates
and thus mitigate the stress such fluctuations might put on the financial system. The
policymakers involved in establishing the Federal Reserve also believed that the institution
would be able to meet the needs of the financial system at times when there was an
unanticipated scramble for liquidity. The founders tended to focus on the ability to rediscount
commercial loans at the discount window, which was seen as a way of providing an elastic
currency that would eliminate crises or at least mitigate them.7
3
As discussed, for example, in Sprague (1910); Mishkin (1991); and Calomiris and Gorton (1991).
4
A description of what occurred in this panic is in Sprague (1910); Friedman and Schwarz (1963); Mishkin
(1991); Tallman and Moen (1998); and Odell and Weidenmier (2004).
5
Following the panic of 1907, Senator Aldrich noted that "the shrinkage in values of securities and property and
the losses from injury to business, resulting from and incidental to the crisis, amounted to thousands of
millions of dollars" (Aldrich, 1908).
6
As discussed, for example, in Miron (1986).
7
According to Charles Hamlin, the first head of the Federal Reserve Board, "[During periods of hoarding,] each
bank retreats into its own citadel at the sound of danger and at a time when it should be drawing upon its
reserves to help the business man of the community, it stays aloof, piling up reserves... such a state of affairs
will never occur again under the Federal reserve system. The mobilization of reserves and the turning of
commercial paper [loans] into a liquid investment, will enable every bank to draw down its reserves with
confidence that it can replace them at will if it has proper commercial paper at its disposal" (Hamlin, 1914).
BIS Review 123/2007
The Federal Reserve as a liquidity provider
In past research, I have examined the importance of liquidity provisions by central banks in
overcoming the problem of asymmetric information, exacerbated by the increase in interest
rates, and the uncertainty that generally accompany a financial crisis (Mishkin, 1997).
Increased liquidity can help restrain rising interest rates and, amid an environment of
heightened uncertainty, enable the institutions best able to make judgments about the
creditworthiness of prospective borrowers to provide credit.
Over time, the Federal Reserve has used various methods to provide liquidity to the financial
system. At first, the ability to rediscount paper was seen as the main tool with which to
provide liquidity. At other times, the Federal Reserve has changed interest rate ceilings or
used open market operations. Since 2003, the operation of the discount window has altered
significantly. The new facility allows banks in sound financial condition to borrow at will at a
rate above the target federal funds rate. The facility can be used to provide liquidity to
financial institutions during a crisis in which financial markets become dysfunctional as well
as during other periods of financial tightness that are not the result of a systemic event.
Even with the Federal Reserve System in place, periods of financial stress have arisen since
World War II. I will briefly review a few of the more recent ones and focus on the role of the
Federal Reserve as a liquidity provider in mitigating them. The first of these more recent
episodes arose from the 1970 bankruptcy of the Penn Central Corporation, an important
issuer of commercial paper. Policymakers and market participants worried that the
bankruptcy of such a major issuer would have a chilling effect on the commercial paper
market, as uncertainties about the quality of other issuers would impede them from rolling
over their commercial paper to obtain short-term financing.8 The Penn Central bankruptcy
thus had the potential to send other companies into bankruptcy and possibly trigger a
fullscale financial panic. To forestall this possibility, the Federal Reserve provided liquidity to
financial markets in two ways. First, the Federal Reserve Banks let the depositories in their
respective Districts know that the discount window was available to enable them to make
loans to customers who could not roll over their commercial paper. Second, the Federal
Reserve (along with the Federal Deposit Insurance Corporation and the Federal Home Loan
Bank Board) suspended the interest rate ceilings imposed by the Federal Reserve's
Regulation Q on some large certificates of deposit, thus providing banks another means of
financing increases in loans.
The second recent episode of financial instability was the stock market crash of 1987. A
significant concern during this episode was the possibility of a breakdown in the clearing and
settlement systems in the equity and futures markets. To keep those markets functioning in
an orderly fashion, brokerage firms needed to obtain massive amounts of credit from banks
to meet margin calls from the clearing and settlement institutions. However, although
brokerages were clearly in need of additional funds to finance their activities, banks were
understandably nervous about the health of securities firms in the wake of the
unprecedented market movements.9 In response, the Federal Reserve issued a statement
affirming its readiness to serve as a source of liquidity to support the economic and financial
system. The Federal Reserve underscored its commitment to providing liquidity by
conducting open market operations in a high-profile manner and earlier than usual.10 The
Federal Reserve also communicated with market participants to support efforts to coordinate
a market response (Greenspan, 1994).
What is remarkable about this episode is the relatively limited amount of liquidity extended by
the Federal Reserve: In the immediate aftermath of the crash, it temporarily injected through
open market operations about $12 billion, which at the time was a notable but not
exceptional amount. Because the Federal Reserve acted promptly (within a day) to prevent
the financial system from seizing up, banks were not as reluctant to lend their funds to
securities firms as they presumably would have been in the absence of a stabilizing action
from the central bank. Thus, the Fed did not need to lend directly to the banks to encourage
them to lend to the securities firms that needed funds to clear their customers' accounts.
Confidence was restored, and the fear of crisis subsided quickly.
The ability of the Federal Reserve to provide liquidity was also vital following the terrorist
attacks on September 11, 2001, which disrupted payment, settlement, and communication
systems needed to transfer funds among financial institutions. Unable to receive funds for
their normal operations, many of these institutions turned to the central bank. The Federal
Reserve responded by injecting a considerable amount of liquidity into the system, both
through discount window loans (which soared from around $200 million in the days
immediately before the attacks to a maximum of $46 billion) and repurchase agreements
(which jumped from $25 billion to a peak of more than $80 billion). Further, the Federal
Reserve helped facilitate the provision of dollar liquidity abroad by arranging swap lines with
foreign central banks. Thanks to these steps, credit continued to flow through the system
during the episode, and serious macroeconomic consequences were avoided.
The final episode of financial instability I want to discuss is the market turbulence of the past
few months. Concerns originating in the subprime-mortgage sector sparked a pullback in
risk-taking in a variety of markets. As investors sought safety and liquidity, the issuance and
trading of structured financial products slowed sharply or, in some cases, completely ceased;
some asset-backed commercial paper could not be rolled over; yields in the Treasury bill
market fluctuated considerably; and spreads in interbank funding markets rose to unusually
high levels. To prevent these problems from turning into a severe credit crunch for
households and corporations alike, the Federal Reserve used several tools to inject liquidity
into the system. In particular, on August 10, the Federal Reserve announced that it would
conduct open market operations necessary to promote trading in the interbank market at
close to the target federal funds rate and noted that the discount window was available as a
source of funding. On August 17, the Federal Reserve Board approved a reduction of 50
basis points in the discount window's primary-credit rate and announced changes in
practices to allow the provision of term financing to depository institutions in solid financial
condition for as long as thirty days. Also, to help address the heightened safe-haven
demands for Treasury securities, the Federal Reserve announced a temporary reduction -
from 100 basis points to 50 basis points - in the minimum fee for borrowing securities from
the System Open Market Account. Although market functioning has certainly not yet returned
to normal, and while it is still too early to judge their ultimate success, these actions, along
with the policy easing decided at the September FOMC meeting, have helped improve
conditions in several short-term funding markets and instill confidence in investors that
liquidity would be available if needed.
Policy issues
As I have just recounted, the Federal Reserve has been able to reduce the negative
macroeconomic consequences of bouts of financial instability by providing liquidity to
markets and institutions at times of need. The provision of liquidity should thus be seen as a
key tool for the Federal Reserve in its quest to achieve its statutory objectives of maximum
sustainable employment and price stability. The episodes I reviewed here also suggest that
the more quickly liquidity can be provided when financial instability occurs, the more effective
it may be. As I mentioned earlier, the Federal Reserve's quick response to the stock market
crash of 1987 is noteworthy because it meant that only a small amount of liquidity, and no
direct lending, was needed to restore normal market conditions.
Although the provision of liquidity is undoubtedly a useful tool, it is not without potential costs.
Improperly managed, it can lead to increased incentives for banks to take on excessive risk -
that is, it can create another form of moral hazard. That additional moral hazard will worsen,
rather than enhance, the stability of the financial system. The risk of moral hazard increases
if the central bank is perceived to be lending frequently to insolvent financial institutions. That
concern, however, is addressed in the United States by the Federal Deposit Insurance
Corporation Improvement Act of 1991, which establishes certain constraints on the Federal
Reserve's ability to lend to troubled institutions, and by the guiding principle for the operation
of the Federal Reserve's primary-credit facility, namely, to lend only to sound institutions and
on good collateral.11 The need to limit moral hazard by not lending to insolvent institutions
indicates that central banks must have information sufficient to determine whether an
institution with access to the discount window is indeed healthy. That consideration is one
reason that central banks benefit from having some supervisory responsibility for institutions
with access to the discount window (Mishkin, 1994; Bernanke, 2007).
Moral hazard could also arise when a central bank lends in response to liquidity problems,
but I would argue that the risk of that happening might be lower than in the case of lending to
troubled institutions. I have in mind situations in which markets become impaired for
exogenous reasons. In those circumstances - when financial institutions that are otherwise
perfectly solid are at risk of failure because market infrastructures are disrupted or, more
generally, when financial instability originates outside the banking sector - an intervention by
the Federal Reserve would certainly be beneficial, and the creation of perverse incentives
would probably be limited.
The traditional recommendation for the prevention of financial crises goes back to Thornton
(1802) and Bagehot (1873), who argued that, during a panic, the central bank should be a
lender of last resort that lends freely at a penalty rate. Charging a penalty rate is another way
to limit the possible moral hazard arising from liquidity provisions because it gives institutions
an incentive to maintain liquidity sufficient to avoid borrowing at a high rate. Indeed, the
Federal Reserve's standing facility charges an interest rate above the target federal funds
rate for exactly that reason (Madigan and Nelson, 2002).
The Thornton-Bagehot criterion is an important principle, but central banks must also
determine the appropriate penalty rate to apply under the circumstances. For example, when
financial instability originates outside of the banking sector, liquidity made available to banks
may allow them to channel funds to the part of the financial system that has seized up,
thereby helping the recovery of that sector. Indeed, that mechanism seems to have been at
work during the Penn Central bankruptcy episode. However, if banks must pay a substantial
penalty rate to acquire the extra liquidity, they may find it unprofitable to extend loans to the
troubled sector. In such circumstances, the central bank may judge that a lower penalty rate
for borrowing at the discount window is warranted for a time. Lowering the discount rate may
also help underscore the central bank's intent to provide adequate liquidity to promote the
functioning of financial markets. The Federal Reserve took just such an action on August 17
of this year, when it lowered the rate for primary credit by 50 basis points.
When even depository institutions in sound financial condition are constrained in their access
to funding because of information problems or operational disruptions, open market
operations may be incapable of providing reserves to the specific banks in need of funding.
Having a discount facility at its disposal provides a central bank with a more targeted tool for
coping with financial disturbances without promoting inflationary tendencies.
But wouldn't lending at a reduced rate exacerbate moral hazard? That seems to me to be
unlikely so long as two fundamental principles are observed. First, any such lending should
be temporary and implemented only in the highly unusual circumstance in which systemic
risk is clearly present; that restriction should prevent market participants from expecting such
lending to become a normal part of doing business (Brimmer, 1989). Second, commercial
banks - to the extent that they lend out the funds obtained from the central bank - should
remain responsible for their own credit judgments, even in extreme situations.
Conclusion
The Congress has given the Federal Reserve a dual mandate to achieve both price stability
and maximum sustainable employment. The Federal Reserve's role as a provider of liquidity
to cope with episodes of financial instability has been, and will continue to be, critical to its
success in achieving this mandate. How best to perform that role is something that both
academics and policymakers will continue to think about for a long time.
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