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For release on delivery
8:20 a.m. EDT
May 13,2008

Liquidity Provision by the Federal Reserve

Remarks by
Ben S. Bernanke
Board of Governors of the Federal Reserve System
at the
Federal Reserve Bank of Atlanta
Financial Markets Conference
Sea Island, Georgia
May 13,2008

Well-functioning financial markets are an essential link in the transmission of
monetary policy to the economy and a critical foundation for economic growth and
stability. However, since August, severe financial strains have shaken this foundation. A
sharp housing contraction has generated substantial losses on many mortgage-related
assets and a broad-based tightening in credit availability. Consistent with its role as the
nation's central bank, the Federal Reserve has responded not only with an easing of
monetary policy but also with a number of steps aimed at reducing funding pressures for
depository institutions and primary securities dealers and at improving overall market
liquidity and market functioning.)
In my remarks today, I will begin by reviewing the principles that should guide
central banks' actions to support market liquidity. Then, in light of those principles, I
will discuss the liquidity measures implemented by the Federal Reserve in response to the
financial turmoil. I will conclude by offering some thoughts on liquidity regulation.

The Principles Behind Central Bank Liquidity Provisions
The notion that a central bank should provide liquidity to the banking system in a
crisis has a long intellectual lineage. Walter Bagehot's Lombard Street, published in
1873, remains one of the classic treatments of the role of the central bank in the
management of financial crises. Bagehot noted that the basis of a successful credit
system is confidence. In one passage, he writes, "Credit means that a certain confidence
is given, and a certain trust reposed. Is that trust justified? and is that confidence wise?
These are the cardinal questions" (p. 11). He pointed out that confidence is particularly
important in banking and in other situations in which the lender's own liabilities are

1 Primary securities dealers are broker-dealers that trade in U.S. government securities with the Federal
Reserve Bank of New York. The New York Fed's Open Market Desk engages in the trades on behalf of
the Federal Reserve System to implement monetary policy.


viewed as very liquid by its creditors. In such situations, as Bagehot put it, " ... where the
'liabilities,' or promises to pay, are so large, and the time at which to pay them, if exacted,
is so short," borrowers must demonstrate "an instant capacity to meet engagements" (p.
11 ).
Meeting creditors' demands for payment requires holding liquidity--cash,
essentially, or close equivalents. But neither individual institutions, nor the private sector
as a whole, can maintain enough cash on hand to meet a demand for liquidation of all, or
even a substantial fraction of, short-term liabilities. Doing so would be both unprofitable
and socially undesirable. It would be unprofitable because cash pays a lower return than
other investments. And it would be socially undesirable, because an excessive preference
for liquid assets reduces society's ability to fund longer-term investments that carry a
high return but cannot be liquidated quickly.
However, holding liquid assets that are only a fraction of short-term liabilities
presents an obvious risk. If most or all creditors, for lack of confidence or some other
reason, demand cash at the same time, a borrower that finances longer-term assets with
liquid liabilities will not be able to meet the demand. It would be forced either to defer or
suspend payments or to sell some of its less-liquid assets (presumably at steep discounts)
to make the payments. Either option may lead to the failure of the borrower, so that the
loss of confidence, even if not originally justified by fundamentals, will tend to be selfconfirming. If the loss of confidence becomes more general, a broader crisis may ensue.
How should a central bank respond to a sharp increase in the demand for cash or
equivalents by private creditors? Before talking about Bagehot's answer, I should note
that the Bank of England in his time was a hybrid institution--it was privately owned by
shareholders, but it also had a public role. To fulfill its public role, the Bank of England

-3did not in all cases maximize its profits; notably, it held a larger share of its assets in
liquid form than did other banks, thereby foregoing some return. Nevertheless, in the
context of the gold standard, the Bank's stock of liquid assets was relatively modest in
size, raising the possibility that even this quasi-public institution could run out of cash
should the demand for liquidity become high enough. 2 In this context, Bagehot's advice
on how the Bank of England should respond to a generalized liquidity shortage was
somewhat counterintuitive. He wrote:
In opposition to what might be at first sight supposed, the best [policy] ... to deal
with a drain arising from internal discredit, is to lend freely. The first instinct of
everyone is the contrary. There being a large demand on a fund which you want
to preserve, the most obvious way to preserve it is to hoard it--to get in as much as
you can, and to let nothing go out which you can help. But every banker knows
that this is not the way to diminish discredit. This discredit means, 'an opinion
that you have not got any money,' and to dissipate that opinion, you must, if
possible, show that you have money: you must employ it for the public benefit in
order that the public may know that you have it. The time for economy and for
accumulation is before. A good banker will have accumulated in ordinary times
the reserve he is to make use of in extraordinary times. (p. 24)
And what are the terms at which the central bank should lend freely? Bagehot
argues that "these loans should only be made at a very -high rate of interest" (p. 99).
Some modern commentators have rationalized Bagehot's dictum to lend at a high or
"penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for
private-sector banks to provide for adequate liquidity in advance of any crisis. I will
return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact,
the risk of moral hazard did not appear to be Bagehot' s principal motivation for

2 Such a circumstance could arise in two ways: The banking reserve--that is, the liquid assets backing
deposits at the Bank of England--could fall to a low level as a result of heavy discounting or the issue
reserve--that is gold bullion backing Bank of England notes--could run short because of substantial
redemptions by note holders. Indeed, the Bank of England's gold reserves, its ultimate store of liquidity,
along with the gold in circulation, were quite small relative to total sterling deposits in the U.K. banking
system. This implied, as English historian Sir John Clapham (1945) noted, that there was just a "thin film
of gold" (p. 299) tying the pound to the gold standard.


recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing
and thus to help protect the Bank of England's own finite store of liquid assets. 3 Today,
potential limitations on the central bank's lending capacity are not nearly so pressing an
issue as in Bagehot's time, when the central bank's ability to provide liquidity was far
more tenuous.
Bagehot defined a financial crisis largely in terms of a banking panic--that is, a
situation in which depositors rapidly and simultaneously attempt to withdraw funds from
their bank accounts. In the 19th century, such panics were a lethal threat for banks that
were financing long-term loans with demand deposits that could be called at any time. In
modern financial systems, the combination of effective banking supervision and deposit
insurance has substantially reduced the threat of retail deposit runs. Nonetheless, recent
events demonstrate that liquidity risks are always present for institutions--banks and
nonbanks alike--that finance illiquid assets with short-term liabilities.
For example, since August, mortgage lenders, commercial and investment banks,
and structured investment vehicles- have experienced great difficulty in rolling over
commercial paper backed by subprime and other mortgages. More broadly, a loss of
confidence in credit ratings led to a sharp contraction in the asset-backed commercial
paper market as short-term investors withdrew their funds. And remarkably, some
financial institutions have even experienced pressures in rolling over maturing repurchase
agreements (repos). I say "remarkably" because, until recently, short-term repos had
always been regarded as virtually risk-free instruments and thus largely immune to the

A high rate, Bagehot (1873) wrote, "will prevent the greatest number of applications by persons who do
not require it" (p. 99) and ensure tnat "no one may borrow out of idle precaution without paying well for it;
that the [Bank of England's] reserve may be protected as far as possible" (p. 99). Moreover, as Clapham
(1945) observed, higher interest rates during a period of crisis would draw in gold from abroad, easing
strains on the Bank.

-5type of rollover or withdrawal risks associated with short-term unsecured obligations. In
March, rapidly unfolding events demonstrated that even repo markets could be severely
disrupted when investors believe they might need to sell the underlying collateral in
illiquid markets. Such forced asset sales can set up a particularly adverse dynamic, in
which further substantial price declines fan investor concerns about counterparty credit
risk, which then feed back in the form of intensifying funding pressures.
Recent research by Allen and Gale (2007) confirms that, in principle at least, "fire
sales" forced by sharp increases in investors' liquidity preference can drive asset prices
below their fundamental value, at significant cost to the financial system and the
economy. Their work underscores the basic logic in Bagehot's prescription for crisis
management: A central bank may be able to eliminate, or at least attenuate, adverse
outcomes by making cash loans secured by borrowers' illiquid but sound assets. Thus,
borrowers can avoid selling securities into an illiquid market, and the potential for
economic damage--arising, for example, from the unavailability of credit for productive
purposes or the inefficient liquidation of long-term investments--is substantially reduced.
Liquidity Powers of Other Central Banks

This prescription for providing liquidity in a crisis is simple in theory, but, in
practice, it can be far more complicated. For instance, how should the central bank
distinguish between institutions whose liquidity pressures stem primarily from a
breakdown in financial market functioning and those whose problems fundamentally
derive from underlying concerns about their solvency? The answer, at times, is by no
means straightforward. There are other complexities, too. Central banks provide
liquidity through a variety of mechanisms, including open market operations and direct

-6credit extension through standing lending facilities. The choice of tools in a crisis
depends on the circumstances as well as on specific institutional factors.
The European Central Bank (ECB), for example, routinely conducts open market
operations with a wide range of counterparties against a broad range of collateral. In
recent months, in light of intense pressures in term funding markets, the ECB has
provided relatively large quantities of reserves through longer-term open market
operations. Extending this strategy, the ECB also introduced a new refinancing operation
with a six-month maturity. The first of these was executed on April 2 and was well
received. The Bank of England has followed a similar strategy, expanding their term
open market operations and accepting a wider range of collateral. Very recently, the
Bank of England also initiated a special liquidity facility that allows banks to swap highquality mortgage-backed and other securities for U.K. Treasury bills.
Differences in legal and institutional structure have affected the methods used by
various central banks to inject liquidity in their markets. In the United States, in ordinary
circumstances only depository institutions have direct access to the discount window, and
open market operations are conducted with just a small set of primary dealers against a
narrow range of highly liquid collateral. In contrast, in jurisdictions with universal
banking, the distinction between depository institutions and other types of financial
institutions is much less relevant in defining access to central bank liquidity than is the
case in the United States. Moreover, some central banks (such as the ECB) have greater
flexibility than the Federal Reserve in the types of collateral they can accept in open
market operations. As a result, some foreign central banks have been able to address the
recent liquidity pressures within their existing frameworks without resorting to
extraordinary measures. In contrast, the Federal Reserve has had to use methods it does

-7not usually employ to address liquidity pressures across a number of markets and
institutions. In effect, the Federal Reserve has had to innovate in large part to achieve
what other central banks have been able to effect through existing tools.
The financial distress since August has also underscored the importance of
international cooperation among central banks. For some time, central banks have
recognized that managing crises involving large financial institutions operating across
national borders and in multiple currencies can present difficult challenges. Funding
pressures can easily arise in more than one currency and in more than one jurisdiction. In
such cases, central banks may find it essential to work closely together. For just this
reason, the Federal Reserve, the ECB, and the Swiss National Bank have established
currency swap arrangements and have coordinated their provision of dollar liquidity to
international financial institutions over recent months.

Federal Reserve Liquidity Operations
In the United States, open market operations have long been the principal tool
used by the Federal Reserve to manage the aggregate level of reserves in the banking
system and thereby control the federal funds rate. The discount window has typically
functioned as a backstop, serving as a source of reserves when conditions in the federal
funds market tighten significantly or when individual depository institutions experience
short-term funding pressures. Throughout much of the Federal Reserve's history, this
basic structure has proven adequate to address liquidity pressures, even during some
periods of market turmoil.
However, it became abundantly clear that this traditional framework for liquidity
provision was not up to addressing the recent strains in short-term funding markets. In
particular, the efficacy of the discount window has been limited by the reluctance of

-8depository institutions to use the window as a source of funding. The "stigma"
associated with the discount window, which if anything intensifies during periods of
crisis, arises primarily from banks' concerns that market participants will draw adverse
inferences about their financial condition if their borrowing from the Federal Reserve
were to become known.
The Federal Reserve has taken steps to make discount window borrowing through
the regular primary credit program more attractive. Most notably, we narrowed the
spread of the primary credit rate over the target federal funds rate from 100 basis points
in August to only 25 basis points today. In addition, to address the pressures in term
funding markets, we now permit depositories to borrow for as long as 90 days, renewable
at their discretion so long as they remain in sound financial condition. These actions
have had some success in increasing depository institutions' willingness to borrow.
Moreover, the existence of the option to borrow through the discount window, even if not
exercised, likely has improved confidence by assuring depository institutions that
backstop liquidity will be available should they need it.
Still, the continuing disruptions in short-term funding markets over recent months
suggested that new ways of providing liquidity were necessary. 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 T AF, apparently because of its competitive auction format and the
certainty that a large amount of credit would be made available, appears to have


overcome the stigma problem to a significant degree. Indeed, a large number of banks-ranging from 52 to more than 90--have participated in each of the 11 auctions held thus
far. The T AF has also simplified the implementation of monetary policy by providing
greater predictability of the level of borrowings by depository institutions and
consequently of bank reserves. The size of individual T AF 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.
The recent market turmoil has also affected the liquidity positions of financial
institutions that do not ordinarily have access to the discount window. In particular, prior
to the recent experience, it was believed that primary dealers were not especially
susceptible to runs by their creditors. Primary dealers typically rely on short-term
secured financing arrangements, and the collateralization of those borrowings was
thought sufficient to maintain the confidence of investors. Consequently, dealers'
liquidity management policies and--contingency plans were typically based on the
assumption that they would not be faced with a sudden loss of financing.
But these beliefs were predicated on the assumption that financial markets would
always be reasonably liquid. As I have already noted, recent events have proven that
assumption unwarranted, and the risk developed that liquidity pressures might force
dealers to sell assets into already illiquid markets. This might have resulted in Allen and
Gale's fire sale scenario that I mentioned earlier, in which a cascade of failures and
liquidations sharply depresses asset prices, with adverse financial and economic

- 10This heightened risk led the Federal Reserve to expand its ability to supply
liquidity to primary dealers. In March, to ease strains that had developed in the agency
mortgage-backed securities market, the Federal Reserve initiated as part of its openmarket operations a series of single-tranche repurchase transactions with terms of roughly
28 days and cumulating to up to $100 billion. For the purposes of these transactions,
primary dealers can deliver as collateral any securities eligible in conventional open
market operations. Additionally, the Federal Reserve introduced the Term Securities
Lending Facility (TSLF), which allows primary dealers to exchange less-liquid securities
for Treasury securities for terms of 28 days at an auction-determined fee. Recently, the
Federal Reserve expanded the list of securities eligible for such transactions to include all
AAAIAaa-rated asset-backed securities.

By mid-March, however, the pressures in short-term financing markets intensified,
and market participants were speCUlating about the financial condition of Bear Steams, a
prominent investment bank. On March 13, Bear advised the Federal Reserve and other
government agencies that its liquidity position had significantly deteriorated, and that it
would be forced to file for bankruptcy the next day unless alternative sources of funds
became available. A bankruptcy filing would have forced Bear's secured creditors and
counterparties to liquidate the underlying collateral and, given the illiquidity of markets,
those creditors and counterparties might well have sustained losses. If they responded to
losses or the unexpected illiquidity of their holdings by pulling back from providing
secured financing to other firms, a much broader liquidity crisis would have ensued. In
such circumstances, the Federal Reserve Board judged that it was appropriate to use its
emergency lending authorities under the Federal Reserve Act to avoid a disorderly
closure of Bear. Accordingly, the Federal Reserve, in close consultation with the

- 11 -

Treasury Department, agreed to provide short-term funding to Bear Steams through
JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase
Bear Stearns and assumed the company's financial obligations. The Federal Reserve,
again in close consultation with the Treasury Department, agreed to supply term funding,
secured by $30 billion in Bear Steams assets, to facilitate the purchase.
In a further effort to short-circuit a possible downward spiral in financing markets,
the Federal Reserve used its emergency authorities to create the Primary Dealer Credit
Facility (PDCF). The PDCF allows primary dealers to borrow at the same rate at which
depository institutions can access the discount window, with the borrowings able to be
secured by a broad range of investment-grade securities. In effect, the PDCF provides
primary dealers with a liquidity backstop similar to the discount window for depository
institutions in generally sound financial condition.
To date, our liquidity measures appear to have contributed to some improvement
in financing markets. The existence of the PDCF seems to have bolstered confidence
among primary dealers' counterparties (including the clearing banks, which provide the
dealers with critical intra-day secured credit). In addition, conditions in the Treasury
repo market, which became very strained around mid-March, have improved
substantially. Liquidity is better in several other markets as well. For example, spreads
on agency mortgage-backed securities have dropped in recent weeks after reaching very
high levels in mid-March, as have spreads between conforming fixed-rate mortgage rates
and Treasury rates. Spreads on jumbo mortgage loans have retraced a portion of their
earlier large increases, but recent regulatory and legislative changes make it difficult to
assess the impact of liquidity measures in that segment of the market. Corporate debt
spreads have also declined somewhat from recent highs.

- 12 These are welcome signs, of course, but at this stage conditions in financial
markets are still far from normal. A number of securitization markets remain moribund,
risk spreads--although off their recent peaks--generally remain quite elevated, and
pressures in short-term funding markets persist. Spreads of term dollar Libor over
comparable-maturity overnight index swap rates have receded some from their recent
peaks but remain abnormally high.


Funding pressures have also been evident in the

strong participation at recent T AF auctions even after the recent expansions in auction
sizes, and, of late, depository institutions have borrowed significant amounts under the
primary credit program for terms of up to 90 days.
Ultimately, market participants themselves must address the fundamental sources
of financial strains--through deleveraging, raising new capital, and improving risk
management--and this process is likely to take some time. The Federal Reserve's various
liquidity measures should help facilitate that process indirectly by boosting investor
confidence and by reducing the risks of severe disruption during the period of adjustment.
Once financial conditions become more normal, the extraordinary provision of liquidity
by the Federal Reserve will no longer be needed. As Bagehot would surely advise, under
normal conditions financial institutions should look to private counterparties and not
central banks as a source of ongoing funding.

Liquidity Regulation and Moral Hazard
The provision of liquidity by a central bank can help mitigate a financial crisis.
However, central banks face a tradeoff when deciding to provide extraordinary liquidity
support. A central bank that is too quick to act as liquidity provider of last resort risks
inducing moral hazard; specifically, if market participants come to believe that the


Libor is the London interbank offered rate, a standard measure of the cost of funds in the interbank market.

- 13 Federal Reserve or other central banks will take such measures whenever financial stress
develops, financial institutions and their creditors would have less incentive to pursue
suitable strategies for managing liquidity risk and more incentive to take such risks.
Although central banks should give careful consideration to their criteria for
invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be
most effectively addressed by prudential supervision and regulation that ensures that
financial institutions manage their liquidity risks effectively in advance of the crisis.
Recall Bagehot's advice: "The time for economy and for accumulation is before. A
good banker will have accumulated in ordinary times the reserve he is to make use of in
extraordinary times" (p. 24). Indeed, under the international Basel II capital accord,
supervisors are expected to require that institutions have adequate processes in place to
measure and manage risk, importantly including liquidity risk. In light of the recent
experience, and following the recommendations of the President's Working Group on
Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their
policies and guidance regarding liquidity risk management to determine what
improvements can be made. In particular, future liquidity planning will have to take into
account the possibility of a sudden loss of substantial amounts of secured financing. Of
course, even the most carefully crafted regulations cannot ensure that liquidity crises will
not happen again. But, if moral hazard is effectively mitigated, and if financial
institutions and investors draw appropriate lessons from the recent experience about the
need for strong liquidity risk management practices, the frequency and severity of future
crises should be significantly reduced.

- 14 References
Allen, Franklin, and Douglas Gale (2007). Understanding Financial Crises, Clarendon
Lectures in Finance. Oxford: Oxford University Press.
Bagehot, Walter (1873). Lombard Street: A Description of the Money Market. London:
King. Reprint, Gloucester, U.K.: Dodo Press, 2006.
Clapham, John (1945). The Bank of England: A History. Cambridge, U.K.: Cambridge
University Press.
President's Working Group on Financial Markets (2008). "Policy Statement on Financial
Market Developments," March,
www.treas. gov/press/releases/reports/pwgpolicystatemktturmoil_03122008. pdf.