José Gabilondo


During the last financial crisis, what should the Federal Reserve (the Fed) have done when lenders stopped making loans, even to borrowers with sterling credit and strong collateral? Because the central bank is the last resort for funding, the conventional answer had been to lend freely at a penalty rate against good collateral, as Walter Bagehot suggested in 1873 about the Bank of England. Acting thus as a lender of last resort, the central bank will keep solvent banks liquid but let insolvent banks go out of business, as they should. The Fed tried this, but when the conventional wisdom did not work, it provided liquidity to new products and firms using authority enacted during the Great Depression to deal with financial emergencies—section 13(3) of the Federal Reserve Act (the Act).This Article focuses on the historical, legal, and policy justifications for the Fed’s actions and concludes that the Fed’s actions were readily defensible on several grounds. First, the Fed’s recent efforts were just the latest expression of the Fed’s open-ended authority to trade financial products for its own account, especially during credit emergencies. Second, the policy rationale for these efforts is that credit market dynamics had become influenced by a “shadow banking” sector that a traditional lender of last resort could not reach. To influence the contemporary version of the traditional credit function—borrowing short to lend long term—the Fed would have to expand its emergency liquidity facilities. Finally, the Fed’s market making is congruent with the Fed’s century-old symbiotic relationship with banks, so we should reconsider our naiveté about what has long been a corporatist relationship.