Study: Fed actions worked during meltdown


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In 2007 and 2008, the American economy teetered on the edge of an economic abyss. As fears of economic collapse grew, the Federal Reserve rode in in an attempt to save the day.

At the time, the Fed took extraordinary steps to help prop up the U.S. banking system. Immediately, critics cried foul, accusing Fed officials of overstepping their mandate.

In recent years, it has become fashionable to claim that the Fed actions were largely a failure. Some skeptics say the Fed’s moves provided either only a minor boost to the economy or actually made the situation worse.

However, such conclusions miss the mark, according to a new paper co-authored by Jennifer Dlugosz, assistant professor of finance at the Olin Business School at Washington University in St. Louis.

Dlugosz and her colleagues found that a careful analysis of the facts reveals that two key Fed actions — extending the so-called “discount window” and establishing the Term Auction Facility — likely helped banks increase their lending.

She outlined a few key study findings in the following interview.

More On The Federal Reserve:

During the financial meltdown of a few years ago, the Federal Reserve took some steps to encourage banks to lend. Can you briefly summarize what those steps were and why they were controversial?

The Federal Reserve used a wide variety of approaches to support the banking system during the crisis. We examine the Fed’s “lender of last resort” facilities for commercial banks, which banks used them and whether this backup source of funding helped to promote bank lending. The two programs we look at are the discount window and the Term Auction Facility (TAF).

In 2007-08, as concerns about subprime mortgages grew, banks had increasing difficulty obtaining funding, as seen by the dramatic increase in bank funding rates during this period. In response, the Fed expanded its longstanding discount window program to provide term (rather than overnight) funding and lowered the cost of funds.

Then in December 2007, the Fed established the Term Auction Facility, which was essentially an alternative to the discount window.

It is well-known that banks experiencing liquidity shocks tend to cut back on lending. The question is whether the Fed’s provision of short-term credit to such banks can increase lending or whether it is “pushing on a string.”

You say that despite this controversy, the Federal Reserve was successful in achieving its goals. Please explain how you reached this conclusion.

There is a widely held notion that government support for banks during the crisis was ineffective or did not help Main Street, only Wall Street. Typically, this belief rests on the casual observation that the economy was still in bad shape, despite all of the interventions.

But that does not necessarily imply that the interventions did not work. It is possible that things would have been even worse in the absence of the interventions. Another way to say it is, when evaluating the results of a program, one needs to control for other factors being what they were.

We use a pretty standard approach, multivariable regression, to estimate the effect that receiving discount window and TAF funding has on bank lending to firms and households. We also use some more sophisticated econometric techniques to ensure that we are picking up causal effects, not just correlations.

While the Fed has served as a lender of last resort to the banking system since its inception, relatively little is known about the impact because the identities of the borrowers have historically been kept secret. Information on crisis-time borrowing was made public due to disclosure requirements in the Dodd-Frank (Wall Street Reform and Consumer Protection) Act and Freedom of Information Act requests filed by various media outlets.

Going back to your original question, it might be more accurate to say that this novel data allowed us to perform a careful analysis where previously there were mostly untested beliefs.

The general perception is that ever since the meltdown began, banks have been hoarding cash rather than lending it out. But you say that is not true. Why not?

Our results really focus on these two particular programs, so they cannot necessarily speak to the overall liquidity decisions made by banks. However, it does not appear that funds from these programs were hoarded.

In the same way that we examined how bank lending moved with discount window and TAF funding, we also examine how cash and liquid securities on the balance sheet moved with it. For large banks, we do not find any evidence that the funds were used to liquefy balance sheets. For small banks, we see some increase in security holdings, but the increase in lending is larger, on average.

Another widely held perception is that financial support from the federal government created a “moral hazard.” The worry is that banks that are bailed out will engage in reckless behavior because they don’t have to worry about the consequences of their actions. But you say banks are not lending recklessly. Please explain what you found.

We used the Fed’s Survey of Terms of Business Lending (data) to examine changes in borrower quality and lending terms. This is a quarterly survey of lending terms on commercial and industrial loans by about 350 banks, including all of the largest banks and some smaller banks.

We find that, among banks receiving funding from the Fed, loan quality improved at small banks and remained unchanged at large banks, while lending terms were unchanged at both.