International considerations were critical in the crisis of 2007–08. The first special lending program introduced by the Federal Reserve — the Term Auction Facility — was dominated by foreign financial institutions. The TAF, introduced in December 2007, auctioned term credit from the Reserve Banks' discount windows. Foreign institutions held large dollar-denominated positions in illiquid assets, such as mortgage-backed securities, that they had trouble funding. Banks in the U.S. had access to borrowing from the Federal Home Loan Banks and made major use of that source of funds when credit risk premiums rose in the third quarter of 2007.

The TAF combines aspects of open market operations and the discount window. The legal form of the TAF is the same as that of regular discount window loans. But by providing funds through an auction mechanism rather than through a standing facility, the TAF resembles open market operations rather than the standard discount window and, partly as a result, it appears to have largely avoided the stigma problem that limited the effectiveness of the discount window. Important questions for the Federal Reserve going forward are whether the benefits of the TAF warrant its maintenance on an ongoing basis or whether, now that the TAF has been developed, it can be brought off the shelf sufficiently quickly if warranted by circumstances.

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.

Since the onset of the crisis, the Fed has massively expanded the provision of liquidity to financial institutions, thereby easing the broader credit crunch. Serving as lender of last resort is a time-honored function for central banks and is critical in mitigating systemic risk. But in doing so during the current crisis, the Fed has crossed traditional boundaries by extending the maturity of the loans, the range of acceptable collateral, and the range of eligible borrowing institutions. At the onset of the crisis, the Fed encouraged banks to use the discount window. The apparent stigma associated with use of the window, however, discouraged banks from borrowing. To address this problem, the Fed introduced and has substantially expanded a new auction system (the Term Auction Facility or TAF) to distribute discount window loans.

Normally, most central banks supply and absorb reserves primarily in the safest and most liquid parts of the money markets.  In these segments of the markets they can operate in size without distorting prices, and without preferential treatment for certain private borrowers or forms of collateral. The private sector then distributes the reserves around the markets--across counterparties, maturities, and degrees of creditworthiness. The resulting transactions enhance market liquidity and allow private market participants to allocate credit and determine the appropriate compensation for taking risk.

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets. In fact, several of the Federal Reserve's new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted but to make participation uneconomic when markets are functioning well. Under current law, our facilities for investment banks that don't involve securities eligible for open market operations (OMO-eligible paper) will necessarily be wound down when circumstances are no longer "unusual and exigent"; I'll come back to questions about these facilities in a minute.

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose. They have been successful at reducing the stigma that can impede borrowing at the discount window in a crisis environment and might be very useful in dealing with future episodes of illiquidity in money markets. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order. The latter might require that we allow the auction to set the price without a constraining minimum, but a small auction should not distort the allocation decisions of private participants.

Last December, the Federal Reserve introduced the Term Auction Facility, or TAF, through which predetermined amounts of discount window credit are auctioned every two weeks to eligible borrowers for terms of 28 days. In effect, TAF auctions are very similar to open market operations, but conducted with depository institutions rather than primary dealers and against a much broader range of collateral than is accepted in standard open market operations...  The size of individual TAF auctions has been raised over time from $20 billion at the inception of the program to $75 billion in the auctions this month. We stand ready to increase the size of the auctions further if warranted by financial developments.

These new facilities are Ben’s initiatives. He has been willing to take a fresh look at how the system works and press the boundaries in a thoughtful way.

[I]t is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities.

It is appalling where we are right now. [The Fed has introduced] a backstop for the entire financial system.

Similarly, firms’ concerns about signaling have hampered the ability of the Federal Reserve to encourage borrowing from the Discount Window during times of stress. A particularly interesting example of this occurred last week with the latest auction conducted under the auspices of the Federal Reserve’s new Term Auction Facility (TAF).

The results of the latest TAF auction are shown on Figure 1. Allow me to provide a bit of background.

The TAF is an alternative to a Discount Window loan. Both result in a loan from the Federal Reserve to a financial institution, collateralized by assets that the borrowing institution has pledged to the Federal Reserve. However, with the addition of the TAF, financial institutions have two ways to borrow from the Discount Window. They can borrow using a traditional Discount Window loan, which is a loan at the primary credit rate – traditionally overnight but now up to 90 days term.2 Currently the primary credit rate is 25 basis points over the Federal Funds rate, or a rate of 2.5 percent. Alternatively, they can borrow for 28 days by participating in the Term Auction Facility, where the bidder is free to bid for funds at any rate above the minimum required for the auction (2.11 percent in the latest auction), and all those bids that are above the stop-out rate get the stop-out rate for the loan.

As can be seen in the graph, last week the stop-out rate was 2.82 percent, significantly higher than the primary credit rate of 2.5 percent. Such a bid could be explained if market participants believed it was likely that market rates would rise over the 28 day term, but evidence from trading in Federal Funds futures and in overnight index swaps indicate the opposite – that market participants believe it is far more likely that the Federal Funds rate will fall from its current target. Similarly, the TAF stop-out rate exceeds the one-month London Interbank Offered Rate (Libor), the rate at which banks can borrow one month unsecured money in London.
So how can this seeming anomaly be explained?

First, the Federal Reserve does not trade for profits in the markets, so the firms can bid in the auctions without fearing that their bids imply any immediate signaling of potential balance-sheet constraints or liquidity problems to the counterparty, the Federal Reserve. As a result, firms may be willing to pay a premium for transacting with the Federal Reserve in order to avoid any immediate public signaling, and to avoid taking actions that could potentially be construed as signaling the existence of problems.

Second, firms may want to be sure that they have some term funding, and by placing bids well above the primary credit rate they are in effect offering the equivalent of a non-competitive bid in a Treasury auction. They are willing to purchase the use of the term funds at whatever the current market clearing price is in the auction, even if there are less-costly options at the Discount Window or with private parties.

Third, the winners of TAF auctions are not disclosed by the Federal Reserve. Of course, neither are institutions that take out Discount Window loans disclosed by name. However, market participants may believe that the auction process, where a variety of 5 banks are jointly acquiring funds, may be interpreted differently than an individual institution borrowing from the Discount Window.

2 Discount Window loans are generally described as overnight loans, and had traditionally been. Due to actions taken by the Federal Reserve in response to market events, however, depository institutions can take Discount Window loans out for any term between overnight and up to 90 days. In August 2007 the Federal Reserve Board announced a change to allow the provision of term financing for as long as 30 days, renewable by the borrower. Then in March 2008 the Board approved an increase in the maximum maturity of primary credit loans to 90 days.

So, in essence a 28-day term Discount Window loan could be secured by a depository institution – a loan that would be similar to using the TAF’s structure, but at lower rate.

Also, it is worth highlighting that another structural difference between the TAF and the Discount Window is that a Discount Window loan can be prepaid at the option of the depository institution while the TAF cannot. This suggests that an institution with all other factors being equal, and absent consideration of any "stigma" or signaling issues, might use the Discount Window over the TAF.

3 By some accounts the reporting of Discount Window borrowing by Federal Reserve District is particularly concerning to a firm in a District which has few large participants – because any large borrowings from within such a District are likely to be done by only a limited pool of institutions, making market speculation more finely focused.

4 Recently, the financial press has reported on market speculation that Libor fixings are being under-reported.

From the footnotes

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

Every other week, the Federal Reserve holds an auction where banks are able to use collateral at the Discount Window to get a loan. Currently the size of each auction is $50 billion. The auctions have been well received, and have generally resulted in financing terms (determined by the auction) that are somewhat above the Federal Funds rate.

To qualify, a bank first needs to be in sound financial condition, as the Federal Reserve must have confidence that the bank will be solvent over the time the loan is extended. While this determination is left to the individual Reserve Bank whose district the institution resides in, it generally requires that the bank not have low supervisory ratings. Second, the institution needs to have collateral at the Federal Reserve. Our Discount officers determine, as best they can, the market value of the collateral and apply an appropriate “haircut.”
There is little question in my mind that both the determination of the potential solvency risk and the evaluation of the institution’s collateral are greatly aided by having experienced bank supervisors at the central bank.

Together these policy actions expand our role by providing liquidity in exchange for sound but less liquid securities. These policy innovations share important features of increasing both the term and the quantity of our lending and making additional quantities of highly liquid Treasury securities available to financial intermediaries. This is intended to reduce uncertainty among financial institutions and allow them to meet the liquidity needs of their clients.

While these policy actions represent major innovations in practice, they are in the spirit of the oldest traditions of central banking. As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely, against good collateral" whenever there is a shortage of liquidity in markets.