I think our authority is extremely limited and it wouldn't be appropriate for us to give loans to Puerto Rico. We have very limited authority to buying municipal debt and the authority we have, if we were buy eligible debt, I don't think it would be helpful to Puerto Rico, and beyond that we have no ability to make emergency loans. We could not use 13.3 or emergency powers of that type to extend the loan to Puerto Rico and I don't think it would be this is inherently a matter for Congress and is not something that's appropriate for the Federal Reserve.

There are nonetheless three major sources of concern about potential weaknesses in the new framework for financial crisis management that has been introduced since the Great Financial Crisis. The first is its failure to resolve the problem of stigma--that is, the stigma of borrowing from the central bank at a time when the financial markets are on guard, looking for signs of weakness in individual financial institutions at a time of overall financial stress. Indeed, some of the Dodd-Frank Act reporting requirements may worsen the stigma problem.

The second is a concern that arises from the nature of financial and other crises. It is essential that we build strong frameworks to deal with potential crisis situations, and Dodd-Frank has done that. But these plans need to ensure that the authorities retain the capacity to deal with unanticipated events, for unanticipated events are inevitable. Retaining the needed flexibility may conflict with the desire to reduce moral hazard to a minimum. But, in simple language: Strengthening fire prevention regulations does not imply that the fire brigade should be disbanded.

Third, this concern is heightened by a related problem: The new system has not undergone its own stress test. That is, in one sense, fortunate, for the financial system will undergo its fundamental stress test only when we have to deal with the next potential financial crisis. That day will likely come later than it would have without Dodd-Frank and the excellent work done by regulators in the United States and around the world in strengthening financial institutions and the financial system. But it will come, and when it comes, we will need the flexibility required to deal with it.

I also believe, however, that as long as regulators retain the discretion to intervene with government funding, the credibility of resolution plans will be at risk. Seemingly urgent short-run considerations will threaten to overshadow the value of establishing and preserving a record of precedents that keep market expectations well-anchored. This is a particular danger for central banks, whose independent balance sheets place their fiscal actions beyond the scope of the legislative appropriations process.15 Credible commitment to orderly unassisted resolutions thus may require eliminating the power of governmental entities to provide ad hoc rescues. This would mean repealing the Federal Reserve's remaining emergency lending powers and further restraining the Fed's ability to lend to failing institutions. And once robust and credible resolution plans are in place, we would be able to responsibly wind down the FDIC's Orderly Liquidation Authority and related financing mechanisms.

The similarities between deposit runs and short-term wholesale funding runs have suggested to some that the policy responses should also be similar. Those taking this position argue for providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale funding, or both. Others, myself included, are wary of any such extension of the government safety net and would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding. Unlike deposit insurance, the savings of most U.S. households are generally not directly at risk in short-term wholesale funding arrangements. And, also unlike insured deposits, there is an argument in the short-term wholesale funding context that counterparties should be capable of providing some market discipline in at least some of the contexts in which such funding is provided.

HULTGREN: Mr. Chairman, as you know, Dodd-Frank requires the Fed to adopt procedures to implement the new limitations on the 13(3) authority, its 13(3) authority. It's now been three years later and the Fed still has not done so. How do you justify the Fed's three-year delay in implementing these basic restrictions on the Fed's authority to bail out non-bank firms?

BERNANKE: Well, first of all, I think that the law is very clear about what we can and cannot do. And I don't think that the absence of a formal rule would allow us to do something which the law prohibits. And I mentioned earlier that the law prohibits us from bailing out individual firms using 13(3). And there would be no way we could do that.

We have made a lot of progress on that rule and I anticipate that we will have that out relatively soon.

It is worth pausing here to review in a little more detail the two key functions performed by a lender of last resort. The first function is to provide a precautionary backstop: to reduce the risk of a financial panic beginning in the first place by ensuring that collateral can always be financed…

The second function of a lender of last resort is to prevent the fire sale of assets by firms facing a sudden loss of funding from spreading contagion across the system and disrupting the provision of credit to the economy. This is particularly important during a financial panic, when the demand for liquidity increases sharply. Only the central bank has the ability to meet this increased demand under any potential circumstances.

We have banking activity—maturity transformation—taking place today outside commercial banks. If we believe these activities provide essential credit intermediation services to the real economy that could not be easily replaced by other forms of intermediation, then the same logic that leads us to backstop commercial banking with a lender of last resort might lead us to backstop the banking activity taking place in the markets in a similar way.

However, any expansion of access to a lender of last resort would require legislation and it would be essential to have the right quid pro quo—the commensurate expansion in the scope of prudential oversight…

The Federal Reserve, with its discount window, was well positioned to provide liquidity to banks by making short-term, collateralized loans. (The discount window was the tool the Federal Reserve could have used, had it chosen, to stem the banking panics of the 1930s.) However, our traditional tools, developed in an earlier era, were of little use in addressing panic in the shadow banking system or in the money market mutual fund industry. So, we engaged in what I call "blue sky thinking"--generating many ideas. Most were discarded, but, crucially, some led to the development of new ways for the Federal Reserve to fulfill the traditional stabilization function of central banks. Using emergency authority last employed during the Depression, we created an array of new facilities to provide backstop liquidity to the financial system (and, as a byproduct, coined many new acronyms). Thus, we were able to help restore the flow of credit to American families and businesses by shoring up important financial markets, such as those for commercial paper and securities backed by consumer loans.

The Federal Reserve Act was designed when most credit flowed through banks, but over time securities markets have assumed a much more prominent role in the distribution of credit. Our ability to preserve financial stability may be enhanced by making sure the Federal Reserve has authority to lend against good collateral to other classes of sound, regulated financial institutions that are central to our financial markets--not on a routine basis, but in some circumstances when the Board of Governors finds that the absence of such lending would threaten market functioning and economic stability. The collateral would have to be of good quality and the institutions sound to minimize any credit risk the Federal Reserve might take. And the institutions would need to be tightly regulated and closely supervised to limit the moral hazard of permitting access to the discount window, even when such access is not routinely granted. I want to be quite clear that I am not referring to lending under section 13(3) to individual troubled institutions, like American International Group. That sort of lending is more appropriately done by the fiscal authorities and conducted only in association with the exercise of new authority to resolve systemically important financial institutions.

[L]iquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.

Indeed, one of the important practical difficulties that confronted the Federal Reserve early in the crisis--and one that appears not to have been anticipated by Bagehot--was the unwillingness of many banks to draw discount window credit because of concerns about stigma.
That unwillingness threatened to undermine the effectiveness of central bank action to combat the crisis. And it was an important motivation behind the decision of the Federal Reserve to establish the Term Auction Facility (TAF) as a means of providing a large volume of term funding to banks through an auction mechanism. The Federal Reserve expected that providing funds through an auction, in which no individual institution can have any assurance of winning funds and where settlement takes place with a lag, would have much less stigma than a standing facility.

[P]ricing the facilities at a penalty rate has the added virtue of building an "exit strategy" into the structure of the programs. In pricing the PDCF, the Federal Reserve followed Bagehot's instruction by setting the interest rate on PDCF credit at the primary credit rate charged to depository institutions.
...
Actually, the pricing of a collateralized loan is multidimensional, and terms other than the interest rate are relevant. In particular, the terms on which collateral for a discount window loan is taken constitute an important additional dimension, and the haircut applied to the collateral is one of the most salient aspects. In establishing haircuts for the PDCF, the Federal Reserve sought to provide financing on terms that were less onerous than could be obtained in the markets during the crisis but also less attractive than those available in the markets in more routine circumstances. Thus, the haircuts set on the primary dealer facilities represented a generalization of the dictum to "lend at a high rate." This generalization has been applied to the Federal Reserve's other liquidity facilities as well. The fact that usage of the Federal Reserve's liquidity facilities has declined markedly--in several cases to zero--as market conditions have improved suggests that the Federal Reserve has been successful in pricing these programs at terms that represent penalties in more normal circumstances.

[S]everal factors potentially impeded the Federal Reserve's ability to lend to such entities. For example, representatives of the money fund industry advised the Federal Reserve that money funds would be unwilling to borrow, partly because investors would recognize that leverage would amplify the effects of any fund losses on remaining shareholders and intensify their incentive to run. Indeed, the Federal Reserve Board approved the establishment of a Direct Money Market Mutual Fund Lending Facility but left it on the shelf after being informed that money funds would be unwilling to use it.¹⁰

Despite Bagehot's advice to lend broadly, practicability requires that central banks not lend to all firms, or even all financial institutions, either in routine circumstances or in a crisis. Rather, central banks generally need to establish eligibility for their facilities using some sharply defined criteria--for example, a banking charter, designation as a primary dealer, and so on--in order to avoid an untenable situation in which it may appear that individual firms are arbitrarily allowed or denied access. But because firms are heterogeneous, central banks also have to accept that, as a practical matter, any set of potential borrowers defined on the basis of institutional features will comprise firms with a range of financial characteristics, so that what is a penalty rate for one firm may not be for another.

The second step toward strengthening the credibility of our commitment to sound monetary policy is to clarify the criteria under which we choose to step in as a lender of last resort. We must spell out when we will intervene in markets or extend unusual credit to firms — and then we must be willing to stick to those criteria. Moreover, we also need to complement such clear commitment with a well-articulated exit strategy from such liquidity or credit programs.

Our lending programs were created for extraordinary times and involve significant intervention in the private markets, but they run contrary to a long-standing and sound Fed practice of trying to minimize the effect of its actions on the allocation of credit across market segments. In my view, such programs are not, and should not, be part of the normal operation of a central bank.

One suggestion that would promote a clearer distinction between monetary policy and fiscal policy and help to safeguard the Fed's independence would be for the Fed and Treasury to reach an agreement whereby the Treasury takes the non-Treasury assets and non-discount window loans from the Fed's balance sheet in exchange for Treasury securities. Such an accord would offer a number of benefits.⁴ First, it would transfer funding for the credit programs to the Treasury — which would issue Treasury securities to fund the programs — thus ensuring that credit policies that place taxpayer funds at risk are under the oversight of the fiscal authority. Second, it would return control of the Fed's balance sheet to the Fed, so that we can continue to conduct independent monetary policy. Going forward, an agreement with Treasury would also state that if the fiscal authority at some point wanted the central bank to engage in lending outside its normal operations and, importantly, should the Fed determine "unusual and exigent circumstances" warranted such action, then any accumulation of nontraditional assets by the Fed would be exchanged for government securities.