Wednesday, April 28, 2021

Professor Baker's The Federal Reserve As Collateral's Last Resort

I’m delighted to share with BLPB readers that my new Essay, The Federal Reserve As Collateral’s Last Resort, 96 Notre Dame L. Rev. 1381 (2021) is now available (here).  Its focus is central bank collateral frameworks, a critical and timely topic that has thus far received scant attention from legal scholars.  I recently blogged about Professor Skinner’s Central Bank Activism.  Regardless of one’s perspective on this issue, it’s crucial to realize that a central bank’s collateral framework is the mechanism that promotes or limits such activism.  The institutional features of these frameworks are a combination of legislation and central bank policy, with the latter arguably being the most important influence on the Fed’s framework.   

As the first paragraph of my Essay explains “Central bank money or liquidity is at the heart of modern economies.  It is issued against collateral designated as eligible by, and on terms defined by, central bank collateral frameworks…what is often underappreciated is that the ultimate practical difference between an illiquid and insolvent firm is whether a firm has assets a central bank, such as the Federal Reserve, will accept as collateral for lending or for purchase, and at what valuation.  What ultimately constitutes “good” or central bank “eligible” collateral, how best to assess its value, and whose perspective on these questions matters most are critical issues at the heart of central bank collateral frameworks.” (footnotes in Essay omitted throughout this post). 

In the financial crisis of 2007-09, the Fed rescued both Bear Stearns and American International Group, but not Lehman Brothers.  Fed officials explained that Lehman did not have collateral sufficient to secure its lending assistanceSome economists have disagreed with this assessment.  Yet regardless of who is right about this issue, “the respective histories of these firms attest to the centrality of collateral and central bank collateral frameworks in modern credit markets.”

Central bank collateral frameworks also impact “the production, liquidity and pricing of assets that markets use as collateral…[and] market discipline and enable indirect bailouts of firms and governments.”  In other words, central bank collateral frameworks can potentially incentivize the production of junk assets. 

Much of my research has focused on clearinghouses.  If the Fed were to provide funding assistance under Dodd-Frank’s Title VIII to a distressed, designated clearinghouse, an important consideration would be the collateral securing such funding.  The loan might be “fully collateralized,” but the type of collateral actually securing the loan and its valuation would bear upon whether the assistance amounted to emergency liquidity provision or a bailout.  As I note in The Federal Reserve As Last Resort, it's curious that while Dodd-Frank added collateral related provisions to the Fed's longstanding Section 13(3) emergency authority, it included no such provisions with the Fed's new liquidity authority in Title VIII for designated financial market utilities such as clearinghouses. 

As the importance of the shadow banking system has increased, so too has the role of collateral in financial markets.  The Fed provided extensive assistance to the shadow banking system in the financial crisis of 2007-09 and in the ongoing COVID-19 pandemic.  Although economists and legal scholars have written about the shadow banking system and the Fed’s emergency liquidity facilities, there has been little focus on central bank collateral frameworks.  More work is needed in this area.  Manmohan Singh’s Collateral Markets and Financial Plumbing and Kjell G. Nyborg’s Collateral Frameworks: The Open Secret of Central Banks are important (and some of the only) contributions in this general area.   

In sum, my Essay is meant to be a “first step in a broader normative project analyzing the proper balance between legislation and central bank policy—between architecture and implementation—in shaping the Federal Reserve’s collateral framework to best promote market discipline and to minimize credit allocation.  Its modest aim is twofold. First, it provides the first analysis of central bank collateral frameworks in the legal scholarship. Second, it analyzes the equilibrium between legislation and central bank policy in the Federal Reserve’s collateral framework in the context of its section 13(3) emergency liquidity authority, lending authority for designated financial market utilities, and swap lines with foreign central banks, and general implications of these arrangements.”        

My article, The Federal Reserve’s Use of International Swap Lines, was the first law review piece to analyze the Fed’s central bank swap lines.  It started with the following quote from an article by John Dizard in the Financial Times: “Always define every issue as just a technical problem.”  Central bank swap lines are anything but a mere technical issue.  Similarly, BLPB readers should understand that the collateral framework of the Fed and other central banks is much more than just a technical central banking problem.  It is a topic that should be of interest to all.

Finally, I’d like to thank NYU School of Law's Classical Liberal Institute and the Notre Dame Law Review for the opportunity to participate in their workshop on The Public Valuation of Private Assets (additional articles here).  And I’d also like to thank Zachary Pohlman, Editor-in-Chief, Lauren Hanna, Symposium Editor, and all of the other members of the Notre Dame Law Review who edited my Essay for their superb work!

Colleen Baker, Financial Markets | Permalink


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