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Summarize how central banks reacted to the crisis.

FRM® Part I · Foundations of Risk Management · Anatomy of the Great Financial Crisis of 2007-2009 · FRM1.FR.10.f

The idea

Central banks acted as lenders of last resort and then went further. The Federal Reserve cut its target rate, which stood at 5.25 percent until September 2007, to a range of 0 to 0.25 percent in December 2008. It created facilities to lend against wider collateral. The Term Auction Facility reduced the stigma of the discount window, and lending then extended to primary dealers and later to money funds and commercial paper issuers. It opened dollar swap lines with foreign central banks, which on-lent dollars to their banks. It used emergency powers to lend to non-banks, including the rescue of Bear Stearns and AIG. At zero rates it began large-scale asset purchases, or quantitative easing, from late 2008. Other central banks also cut rates and widened collateral. The exam point is that rate cuts alone did not repair impaired funding markets.

A practice question

From the question bank, with the reason each wrong option is wrong.

In December 2008 the Federal Reserve cut its target for the federal funds rate to a range of 0 to 0.25 percent. Which tool did it then use to ease policy further?

  1. Large-scale purchases of mortgage and agency securities - correct
  2. Raising reserve requirements on all depository banksWhy not: Higher reserve requirements would tighten, not ease, conditions.
  3. Selling Treasury securities to drain reserves from banksWhy not: Selling securities drains liquidity and tightens policy; the Fed was buying assets.
  4. Cutting its policy rate to well below zeroWhy not: Policy rates in this period were held at the lower bound, and the Fed turned to asset purchases instead.

With the policy rate at the lower bound the Fed announced purchases of agency mortgage-backed securities and agency debt in November 2008 and expanded them in 2009. This quantitative easing aimed to lower long-term rates and mortgage spreads.

A harder one

The Federal Reserve introduced the Term Auction Facility in December 2007. What was its main purpose?

  1. To buy equity tranches of CDOs from banks at a fixed support priceWhy not: The facility lent to depository institutions against collateral and did not purchase CDO tranches.
  2. To lend directly to money market fund investorsWhy not: The facility was for depository institutions; money funds received support through other programmes later.
  3. To auction term loans to banks, reducing the stigma of the discount window - correct
  4. To let foreign banks borrow US dollars directly from the European Central BankWhy not: Dollar provision to foreign banks was done through swap lines with foreign central banks, not this auction.

Banks were reluctant to use the discount window for fear of signalling weakness. Term auctions at market-determined rates let many banks borrow without that stigma, and funds were available for longer terms.

The hardest tier

The Federal Reserve lent to primary dealers through the Primary Dealer Credit Facility and to AIG in 2008. Which statement best describes this departure from the conventional role of a central bank?

  1. It extended emergency credit to non-banks under special powers for exigent circumstances - correct
  2. It lent without collateral to commercial banks at rates far below its policy rateWhy not: The Fed lent against collateral and at rates at or above its policy rate; the departure was the borrowers, not the terms.
  3. It gave up the discount window and lent only through open market operationsWhy not: The discount window remained; the new facilities were added to it.
  4. It guaranteed all liabilities of the banking system against any losses at allWhy not: The Fed made secured loans; it did not guarantee all bank liabilities, which was done by deposit insurance and government guarantee schemes.

Section 13(3) of the Federal Reserve Act allowed lending to individuals, partnerships and corporations in exigent circumstances. It was used for the Bear Stearns transaction, the primary dealers and AIG, moving central bank support beyond banks.

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