University of Colorado Law School Colorado Law Scholarly Commons Articles Colorado Law Faculty Scholarship 2019 Negotiating the Lender of Last Resort: The 1913 Federal Reserve Act as a Debate over Credit Distribution Nadav Orian Peer University of Colorado Law School Follow this and additional works at: https://scholar.law.colorado.edu/articles Part of the Banking and Finance Law Commons, Business Organizations Law Commons, Legal History Commons, and the Legislation Commons Citation Information Nadav Orian Peer, Negotiating the Lender of Last Resort: The 1913 Federal Reserve Act as a Debate over Credit Distribution, 15 N.Y.U. J.L. & BUS. 367 (2019), available at https://scholar.law.colorado.edu/articles/ 1224. Copyright Statement Copyright protected. Use of materials from this collection beyond the exceptions provided for in the Fair Use and Educational Use clauses of the U.S. Copyright Law may violate federal law. Permission to publish or reproduce is required. This Article is brought to you for free and open access by the Colorado Law Faculty Scholarship at Colorado Law Scholarly Commons. It has been accepted for inclusion in Articles by an authorized administrator of Colorado Law Scholarly Commons. For more information, please contact [email protected]. NEW YORK UNIVERSITY JOURNAL OF LAW & BUSINESS VOLUME 15 SPRING 2019 NUMBER 2 NEGOTIATING THE LENDER OF LAST RESORT: THE 1913 FEDERAL RESERVE ACT AS A DEBATE OVER CREDIT DISTRIBUTION NADAV ORIAN PEER* “Lending of last resort” is one of the key powers of central banks. As a lender of last resort, the Federal Reserve (the “Fed”) famously supports com- mercial banks facing distressed liquidity conditions, thereby mitigating de- stabilizing bank runs. Less famously, lender-of-last-resort powers also influ- ence the distribution of credit among different groups in society and therefore have high stakes for economic inequality. The Fed’s role as a lender of last resort witnessed an unprecedented expansion during the 2007–2009 Crisis when the Fed invoked emergency powers to lend to a new set of borrowers known as “shadow banks”. The decision proved controversial and spurred legislative reform narrowing the Fed’s authority as well as an ongoing schol- arly debate. Participants in this debate, the Article argues, limited their focus to financial stability considerations, thereby neglecting those powers’ consid- erable distributive implications. This Article contributes to the current literature by demonstrating the distributive stakes of lender-of-last-resort powers through a concrete historical * Visiting Assistant Professor, Tulane Law School, Fellow at the Murphy Institute, Tulane University. Associate Professor, University of Colorado Law School, starting Fall 2019. For valuable comments and suggestions, I am grateful to Christine Desan, Roy Kreitner, Morton Horwitz, Morgan Ricks, Perry Mehrling, Regina Larrea Maccise, Gustavo Ribeiro, Adam Feibelman, Eli Cook, Noam Magor, Bianca Gardella Tedeschi, Daniela Gabor, Cornel Ban, Annette Burkeen, and Yaniv Ron El. The Byse Fellowship (Harvard Law School), the Weatherhead Center for International Affairs (Harvard Univer- sity), and the Centro di Diritto Comparato e Transnazionale (University of Torino) provided generous financial support and excellent fora for discus- sion. It is a pleasure to acknowledge the help of a wonderfully skillful, crea- tive, and dedicated team of research assistants at Tulane Law School: Radina Angelova, Clayton Christian, Tom Gosselin, and Andrew Taylor. Last but not least, my thanks go to the editors of the New York University Journal of Law & Business for their superb work. 367 368 NYU JOURNAL OF LAW & BUSINESS [Vol. 15:367 example: the legislative debate around the 1913 Federal Reserve Act that established the Fed. During that time, three different groups debated the legal definition of “eligible collateral” that the Fed could accept from borrowers to secure emergency loans. The first group was corporate financiers, who were interested in supporting capital markets. The second group was the Demo- cratic framers of the Act, who tried to divert credit away from corporate securities and into small businesses. The third group was farmers that needed credit for developing the agrarian periphery. I argue that each of these groups tried to shape the definition of eligible collateral in ways that would promote that group’s unique credit needs and reduce its borrowing costs. For us today, this history is an invitation to reconsider the distributive implications of the current lender-of-last-resort powers and revise them ac- cordingly. INTRODUCTION ......................................... 368 I. RECEIVED ACCOUNTS OF THE ORIGINS OF THE FED ............................................. 377 A. The Bagehotian Tradition: Rationalizing Lender of Last Resort ................................ 378 B. The Corporate Liberal Tradition: Lender of Last Resort as Class Conflict . 382 C. The Constitutional Approach: Lender of Last Resort and the Unit of Account . 387 II. THE URBAN-COMPETITIVE AGENDA . 392 A. Democrats’ Anti-Corporate Politics . 393 B. Democrats’ Assault on the Call Loan Market . 397 C. Democrats’ Design for the Federal Reserve Act . 406 III. THE REGIONAL DEVELOPMENT AGENDA . 412 A. The Clash Between the European Ideal and Local Needs ....................................... 413 B. The Debate over “Accommodation Paper”. 418 C. Negotiating Section 13 Eligible Paper . 420 IV. THE CORPORATE AGENDA . 425 A. Life After Competition. 427 B. The Call Loan Market as an Engine of Corporate Finance ..................................... 431 C. The Puzzling Coalition: Corporate Financiers and Mainstream Democrats . 436 Epilogue: The Unrealized Coalition . 446 CONCLUSION ........................................... 450 INTRODUCTION The power to act as a “lender of last resort” is one of the key roles of central banks: in the United States, the Federal 2019] NEGOTIATING THE LENDER OF LAST RESORT 369 Reserve System (the “Fed”).1 As a lender of last resort, the Fed comes to the rescue of banks facing distressed liquidity condi- tions. These liquidity stresses arise occasionally due to “matur- ity mismatch,” which is an essential feature of banking. While banks’ hold their assets in the form of long-term loans, their sources of funding consist primarily of demand liabilities, like deposits.2 When a large number of depositors demand pay- ment simultaneously, a bank cannot liquidate its long-term as- sets with sufficient speed and so must fail.3 This is where the Fed’s lender-of-last-resort powers become relevant. The Fed lends to distressed banks by taking their long-term assets as collateral, and providing them with immediately available funds to make necessary payments to depositors.4 The financial crisis of 2007–2009 witnessed a dramatic ex- pansion in the Fed’s role as a lender of last resort.5 Histori- cally, this role was limited to supporting the traditional com- mercial banking system. In the crisis, the Fed decided to ex- tend its support to the “shadow banking” system that developed over the past decades.6 Shadow banking, in brief, refers to institutions—like broker–dealers, hedge funds and others—that borrow on short maturities (often overnight) and invest in long-term securities.7 Thus, shadow banking is a varia- 1. Ben Bernanke, Fed Emergency Lending, BROOKINGS (Dec. 3, 2015), https://www.brookings.edu/blog/ben-bernanke/2015/12/03/fed-emergen cy-lending/. 2. Id. (“The most important tool that central banks (like the Fed) have for fighting financial panics is their ability to serve as a lender of last resort.”). 3. See, e.g., Anna Gelpern, Common Capital: A Thought Experiment in Cross- Border Resolution, 49 TEX. INT’L L.J. 355, 360 (2014). 4. Bernanke, supra note 1. 5. See, e.g., Michael J. Fleming, Federal Reserve Liquidity Provision During the Financial Crisis of 2007–2009, 4 ANN. REV. FIN. ECON. 161, 167, 175 (2012) 6. See, e.g., Eric A. Posner, What Legal Authority Does the Fed Need During a Financial Crisis?, 101 MINN. L. REV. 1529, 1546 (2017). 7. See PERRY MEHRLING ET AL., BAGEHOT WAS A SHADOW BANKER: SHADOW BANKING, CENTRAL BANKING, AND THE FUTURE OF GLOBAL FINANCE 2, CTR. EUR. U. (2013), https://www.ceu.edu/sites/default/files/attachment/ev ent/6574/nov05-perry-mehrling.pdf (defining shadow banking as “money market funding of capital market lending”). For a different but related defi- nition of shadow banking, see MORGAN RICKS, THE MONEY PROBLEM: RE- THINKING FINANCIAL REGULATION 96 (2016). For a discussion of shadow bank- ing, see also Nadav Orian Peer, Your Grandfather’s Shadow Banking: Clearing and Governance in Gilded Age New York, in INSIDE MONEY: RE-THEORIZING LI- QUIDITY (Christine Desan ed., forthcoming 2019). 370 NYU JOURNAL OF LAW & BUSINESS [Vol. 15:367 tion on the essential feature of banking (maturity mismatch) and is vulnerable to similar liquidity strains.8 The shadow banking system was at the heart of the market for subprime mortgage securitization that had grown rapidly since the early 2000s.9 As pressures grew in that market, the Fed invoked emergency powers in the Federal Reserve Act (the “Act”) that authorized it to lend to counterparties other than commercial banks.10 The Fed’s lender-of-last-resort support to the shadow banking system proved highly controversial. Some welcomed the Fed’s actions as a necessary adaption of the century-old authority to modern financial conditions.11 Others were con- cerned with lack of accountability, moral hazard, and potential ramifications for future financial instability.12 Ultimately, the 2010 Dodd–Frank Act reflected a middle ground between these positions. It posed considerable constraints on the Fed’s emergency powers while not eliminating them altogether.13 8. RICKS, supra note 7, at x. 9. Zoltan Poszar et al., Shadow Banking, 19 ECON. POL’Y REV. 1, 2 (2013). 10. Federal Reserve Act of 1913, Pub. L. No. 63-43, § 13(3), 38 Stat. 251, 263 (1913) (codified as amended at 12 U.S.C. § 343 (2012)). For use of this authority in a crisis, see Posner, supra note 6, at 1546–47. The more common (“peacetime”) authority the Fed uses allows lending on to its own member banks.