Submitted by EconWeekly

Last week I described the traditional tools of the Fed (open market operations and the discount window) and an old, but less well-known one (repurchase agreements). Then I described the first innovation, the Term Auction Facility, inaugurated in December.

This week I’ll go over the forms of lending introduced in 2008, and then I’ll discuss the options that the Fed is rumored to be considering next.

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In 2007 the Federal Reserve made an effort to provide liquidity through channels other than open market operations and repos. To that effect, it created the Term Discount Window Program (TDWP) and the Term Auction Facility (TAF), as I explained last week. Both of those facilities, however, are available only to depository institutions.

So far I’ve been using the ambiguous term “banks” to refer to institutions that borrow funds or buy Treasurys from the Fed. There are however two broad classes of “banks”: depository institutions and primary dealers. Depository institutions are allowed to accept deposits. Primary dealers, on the other hand, are investment banks and brokers that trade in Treasurys with the Federal Reserve. Bear Stearns and Lehman Brothers are two examples in the latter group. As of today, there are 20 of them.

One defining characteristic of depository institutions is that they can use a broad range of assets to secure their loans from the Fed. The discount window, the TDWP and the TAF all accept a set of assets known as “discount collateral.” That includes pretty much all paper of investment quality, including performing sub-prime mortgages. Primary dealers, on the other hand, only have access to open-market operations (OMOs) and repos. The latter only can be obtained after posting General Collateral —that is paper issued by the Treasury or US agencies only.

Following problems in the mortgage and real estate markets last summer, primary dealers found it increasingly hard to obtain short-term financing because nobody would take their suspicious assets as collateral —or would do so only at very high prices. The Fed stepped up to the plate by opening the Term Securities Lending Facility (TSLF) to primary dealers, on March 27. Roughly speaking, a TSLF loan is an exchange of risky securities for Treasuries for 28 days between Federal Reserve and primary dealers. The range of acceptable collateral, although not as wide as at the discount window, includes some types of paper issued by non-agency institutions (AAA/Aaa-rated private label RMBS and CMBS).

To be sure, the Fed has had a securities lending program for a number of years. The novelty of the TSLF is that it extends the range of acceptable collateral beyond Treasuries. A second novelty is that the term of the loans increases from overnight to 28 days.

Unlike the other tools I have discussed, the TSLF does not have an effect on reserve balances by design. This allows the Fed to pursue its recent strategy of providing liquidity to the banking system without increasing the monetary base.

This is what these loans would look like on the balance sheet of the Fed:

4) Remunerate reserves. Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

This reviews my review of the Fed’s new monetary policy. Will these new tools make it to the textbooks? It’s hard to tell whether the particular facilities (TAF, TSLF, etc.) will survive. But I think that some standardized form of loans to non-depository institutions will stay, and that the Fed will become willing to accept dodgier collateral than it traditionally has.

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