The Influence and Limits of Central Bank Backstops
The Federal Reserve has deployed a wide array of emergency lending facilities in response to the economic crisis of the Covid-19 pandemic. By regulation, lending facilities created under the Fed’s emergency powers are “backstops,” charging a penalty interest rate that encourages borrowers to obtain funds in the market when possible. Perhaps as a result, as figure 1 shows, many of the Fed facilities have seen little borrowing, and total use has leveled off as financial stresses have diminished.2 In this post, I explain why central banks offer backstop facilities and describe two ways they influence financial conditions: by providing a safety net and by influencing bargaining in private transactions. I also discuss some limitations of backstops.
The Federal Reserve has deployed a wide array of emergency lending facilities in response to the economic crisis of the Covid-19 pandemic.1 By regulation, lending facilities created under the Fed’s emergency powers are “backstops,” charging a penalty interest rate that encourages borrowers to obtain funds in the market when possible. Perhaps as a result, as figure 1 shows, many of the Fed facilities have seen little borrowing, and total use has leveled off as financial stresses have diminished.2 In this post, I explain why central banks offer backstop facilities and describe two ways they influence financial conditions: by providing a safety net and by influencing bargaining in private transactions. I also discuss some limitations of backstops.
Figure 1. Federal Reserve 13(3) Facilities
Why backstops charge a penalty rate
In a financial crisis, a central bank confronts a tension between the immediate and longer-term potential effects of its actions. In the short term, the central bank can best preserve the flow of credit to households and businesses by making loans when private lenders do not. But in the longer term, if borrowers grow accustomed to the central bank coming to the rescue whenever there are signs of stress, they may waste the funds, take too much risk, or become unduly reliant on central bank credit.
Conventional wisdom among central bankers—dating to the nineteenth-century British essayist Walter Bagehot—calls for balancing these tensions during a crisis by lending freely against good collateral at a penalty interest rate.3 The knowledge that credit is available, even if at a high rate, can calm markets and prevent wider panic. At the same time, the high rate has several benefits:
- In normal times, before a crisis arrives, borrowers understand that central bank credit during a crisis would be expensive. This limits the incentive to take risks in the expectation of a rescue.
- During the crisis, borrowers are discouraged from coming to the central bank without a genuine need.
- When market functioning returns to normal, facilities are “self-liquidating”: Borrowers have an incentive to return to markets, preserving the private sector’s long-run role in allocating capital to its most productive use.
The Federal Reserve Board has adopted these principles in its Regulation A, which specifies that the Fed’s emergency credit facilities4 must charge an interest rate that “affords liquidity” but “is a premium to the market rate in normal circumstances” and “encourages repayment … as the unusual and exigent circumstances that motivated the program or facility recede and economic conditions normalize.”5 Similarly, the Fed’s discount window, though it is not an emergency facility, operates as a backstop by lending to banks at a spread above market rates.6
Backstops as a safety net
Because financial markets have mostly returned to functioning smoothly following the extreme volatility experienced in March and April 2020 and because the Fed’s facilities are priced at penalty rates, many potential borrowers can now find credit at more attractive rates in the market. Does this mean the facilities have little effect on financial conditions and the economy? No. I’ll argue that in an uncertain environment like the one we face today, backstop facilities can meaningfully support the economy even though they may see little day-to-day use.
One reason backstops make a difference is that they provide a safety net against renewed financial market disruptions. For example, an automaker deciding whether to ramp up production must consider whether families will be able to get car loans by the time the new vehicles roll off the line. If there is a risk that renewed market stresses will make auto loans extremely expensive or hard to come by in the future, the automaker may choose not to increase production, even if loans are readily available right now and there is unmet demand for cars. A backstop that helps to ensure auto loans will keep flowing and provides some certainty about interest rates, such as the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF), can give the automaker the confidence needed to make more cars. This confidence can support the economy even though, at the moment, few borrowers may want TALF loans.
Other backstops can provide the confidence that state and local governments and nonprofit organizations need to commit to spending on essential services, that investors need to place funds in the short-term money markets that deliver credit to a wide range of households and businesses, and that small businesses and mid-size corporations need to plan ahead.
A backstop can provide a temporary safety net or a permanent one. The Fed’s emergency lending powers are limited to “unusual and exigent circumstances.” Thus, backstops based on these powers must shut down when the crisis has definitively passed. However, backstops based on other authorities, such as the Fed’s discount window, can be available at all times.
Backstops and bargaining
Credit markets often are not perfectly competitive. Borrowers can most easily get credit from lenders who know them well, which gives a borrower’s regular lenders some bargaining power—if the regular lenders demand a higher-than-market rate, the borrower may have few other places to turn. These pressures can be particularly severe during times of financial stress, as some lenders can pull back from the market, leaving borrowers with even fewer options.
In these circumstances, backstops can help restore competitive pressure. For instance, a state government whose regular lenders demanded a very high rate could turn instead to the Fed’s Municipal Liquidity Facility (MLF). Knowing this, the lenders may limit their demands, which can help the state continue to obtain market credit at reasonable rates without borrowing from the MLF.
A related dynamic arises with the Fed’s non-emergency tools for controlling short-term interest rates to implement monetary policy. The Fed currently offers large-scale repurchase agreement (or “repo”) operations that let securities dealers borrow overnight at slightly above market rates, as well as an overnight reverse repo facility that lets investors lend cash to the Fed at slightly below market rates. Because the repo and reverse repo rates differ slightly from market rates, these operations currently see little transaction volume. However, by giving borrowers and lenders an additional option, these tools can still influence bargaining over the rates on private-sector transactions.7
The limitations of backstops
Although backstops can support the flow of credit without being used, they have limitations. In particular, in setting the interest rate penalty and other parameters of a lending facility, central banks face a tradeoff between supporting the flow of credit and encouraging the use of markets where possible. A smaller interest rate penalty can make the backstop more effective by strengthening the safety net and increasing the facility’s influence on private-sector bargaining, but can also reduce the incentive to seek credit in the market.8 Other dimensions, such as eligibility criteria and the duration of the loans, can also affect how attractive a lending facility is relative to private-sector credit.
Further, backstops aim to support normal market functioning—not to make credit cheaper or more plentiful than what a normally functioning market would deliver. So, for example, in normally functioning markets, it is typically difficult for companies to borrow when their business prospects are poor and they do not have collateral. A backstop lending freely against good collateral at a penalty rate has little to offer such a borrower. In the current context, backstops can help households, businesses, state and local governments, and other borrowers smooth over temporary disruptions in market functioning or temporary needs for credit due to the pandemic, but backstops alone cannot replace the severe losses that many have experienced from the economic downturn. As Chair Jerome Powell has said, “the Fed has lending powers, not spending powers.”9
* I thank colleagues throughout the Federal Reserve System for helpful comments.
1 For an overview of the emergency lending facilities and other Federal Reserve actions in response to the Covid-19 crisis, see Lorie K. Logan, “The Federal Reserve’s Recent Actions to Support the Flow of Credit to Households and Businesses,” remarks before the Foreign Exchange Committee, Federal Reserve Bank of New York, April 14, 2020.
2 In contrast to several other facilities, the Paycheck Protection Program Liquidity Facility (PPPLF) grew gradually in size over the course of the spring, after the period of the largest financial market disruptions. However, the PPPLF differs somewhat in character from the other facilities, as it supports small business loans through a government relief program in response to the pandemic.
3 See Walter Bagehot, 1873, Lombard Street: A Description of the Money Market, New York: Scribner, Armstrong & Co., pp. 196–198.
4 These facilities are created under section 13(3) of the Federal Reserve Act and require the consent of the Treasury secretary.
5 Regulation A, 12 CFR §201.4(d)(7).
6 To support the flow of credit, the Federal Reserve Board reduced this spread near the onset of the Covid-19 crisis.
7 See Sam Schulhofer-Wohl and James Clouse, 2018, “A sequential bargaining model of the fed funds market with excess reserves,” Federal Reserve Bank of Chicago, working paper, No. 2018–08; and Gara Afonso, Roc Armenter, and Benjamin Lester, 2019, “A model of the federal funds market: Yesterday, today, and tomorrow,” Review of Economic Dynamics, Vol. 33, pp. 177–204.
8 In practice, the interest rate on a backstop facility is often specified as a spread over a risk-free market rate. The size of the penalty then depends on how this spread compares with market credit spreads.