Columbia Law School Scholarship Archive Faculty Scholarship Faculty Publications 2016 The First Year: The Role of a Modern Lender of Last Resort Kathryn Judge Columbia Law School, [email protected] Follow this and additional works at: https://scholarship.law.columbia.edu/faculty_scholarship Part of the Banking and Finance Law Commons Recommended Citation Kathryn Judge, The First Year: The Role of a Modern Lender of Last Resort, 116 COLUM. L. REV. 843 (2016). Available at: https://scholarship.law.columbia.edu/faculty_scholarship/106 This Essay is brought to you for free and open access by the Faculty Publications at Scholarship Archive. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of Scholarship Archive. For more information, please contact [email protected]. ESSAY THE FIRST YEAR: THE ROLE OF A MODERN LENDER OF LAST RESORT KathrynJudge* Insufficient liquidity can triggerfire sales and wreak havoc on a financial system. To address these challenges, the Federal Reserve (the Fed) and other central banks have long had the authority to provide financial institutions liquidity when market-based sources run dry. Yet, liquidity injections sometimes fail to quell market dysfunction. When liquidity shortages persist, they are often symptoms of deeper problems plaguing the financial system. This Essay shows that continually pumping new liquidity into a financial system in the midst of a persis- tent liquidity shortage may increase the fragility of the system and, on its own, is unlikely to resolve the deeper problems causing those liquidity shortages to persist. This Essay suggests that when facing persistent liquidity shortages, the Fed should instead use the leverage it enjoys by virtue of controlling access to liquidity to improve its understandingof the ailments causing the market dysfunction to persist and to help address those underlying issues. When liquidity shortages persist, they will often indicate that market participants lack critical information about risk exposures or that they are concernedfinancial institutions or other entities lack suffi- cient capital in light of the risks to which they are exposed. Providing credible information and working with other policymakers to ensure the overall financial system is sufficiently capitalized are thus among the issues that the Fed should prioritize when facing persistent liquidity shortages. This Essay thus provides a new paradigmfor how the Fed can utilize its lender-oflast-resort authority to prevent a nascentfinan- cial crisis from erupting into one that inflicts significant harm on the real economy. * Associate Professor of Law and Milton Handler Fellow, Columbia University. I am grateful to Ryan Bubb, John Coffee, Merritt Fox, Ronald Gilson, Victor Goldberg, Jeffrey Gordon, Prasad Krishnamurthy, Patricia McCoy, Alex Raskolnikov, Morgan Ricks, Robert Scott, and Arthur Wilmarth and participants at the Junior Business Law Conference, University of Colorado, the American Law and Economics Association Annual Meeting, the NYU/ETH Conference on Banking and Finance, and the Columbia Faculty Workshop for helpful comments and discussions. I also want to thank Michael Pfautz, Kelsey Hogan, Samuel Shepson, and Aaron Macris for their exceptional research assistance, and Austin Krist and the other editors at the Columbia Law Review for their thoughtful feedback throughout the editing process. I am grateful to the Milton and Miriam Handler Foundation for financial support. 844 COLUMBIA LAWREVIEW [Vol. 116:843 The heart of this Essay brings these dynamics to life through a close examination of the Fed's actions during the early stages of the 2007-2009 financial crisis (the Crisis). Using transcriptsfrom Fed meetings and other primary materials, this Essay reconstructs the first thirteen months of the Crisis. The analysis reveals more than a year during which Fed officials could have taken an array of actions that may have reduced the size of the Great Recession and the amount of credit risk and moral hazard stemming from the government's sub- sequent interventions. The analysis also demonstrates specific ways that the Fed's lender-of-last-resortauthority could serve as the type of respon- sive and dynamic regulatory tool that the Fed requires when seeking to restore stability during the early phases of a panic. INTRODUCTION ......................................................................................... 845 I. LENDER OF LAST RESORT .................................................................... 850 A. The Crisis ..................................................................................... 855 II. LEVERAGE AS CREDITOR ...................................................................... 858 A. The Claim .................................................................................... 859 B. Identifying a Persistent Liquidity Shortage ................................ 864 C. The Aims: Focusing on Information .......................................... 866 1. Extracting Information ........................................................ 868 2. Information Injections ......................................................... 872 3. Bank Health .......................................................................... 873 III. THE CRISIS .......................................................................................... 873 A. August 2007: The Start ................................................................ 876 1. Extracting Information ........................................................ 878 2. Disseminating Information .................................................. 879 3. Bank Health .......................................................................... 881 B. January 2008: The First Interm eeting Rate Cut ......................... 881 1. Extracting Information ........................................................ 882 2. Disseminating Information .................................................. 885 3. Bank Health .......................................................................... 885 4. Tool Set ................................................................................. 887 C. March 2008: New Liquidity Facilities and the Failure of Bear Stearn s .........................................................................................888 1. Extracting Inform ation ........................................................ 889 2. Disseminating Information .................................................. 893 3. Bank Health .......................................................................... 894 4. Fed Interventions and Market Expectations ....................... 894 D. Summer 2008 .............................................................................. 897 1. Lehman .................................................................................898 2016] LENDER OF LAST RESORT 845 2. Increased but Still Limited Monitoring ............................... 898 3. U nderstanding the Risks ...................................................... 901 4 . A IG ........................................................................................ 9 0 3 E. Easing Away from the Full Backstop .......................................... 907 IV . IM PLICATIO NS ..................................................................................... 91 1 A. Better Outcomes Were Possible ................................................. 913 1. T he Early Stages .................................................................... 913 2. L eh m an .................................................................................9 15 3 . A IG ........................................................................................ 9 1 6 B. Liquidity and Inform ation .......................................................... 919 V . C HA LLENGES ....................................................................................... 92 1 A . F rictio n ........................................................................................ 92 1 B. Other Operational Challenges ................................................... 922 C . B ypass the Fed ............................................................................. 92 3 D. Information Does Not Ensure Action ........................................ 924 E. O ne Tool, M ultiple Aim s ............................................................ 924 C O NCLU SIO N ............................................................................................. 925 INTRODUCTION Dynamism is a central challenge for regulation today.' Nowhere is this challenge more acute than in financial regulation, where the very act of regulating causes activity to move to less regulated spaces. 2 And at no time is the problem more pressing than in the midst of a financial crisis, which often emanates from fragilities in those less regulated domains.3 This Essay reveals that the Federal Reserve (the Fed) need not wait for Congress to expand its oversight authority to tackle these challenges right at their source. It can instead use the leverage it enjoys by virtue of controlling access to liquidity to obtain critical information about the challenges it is facing and to start addressing those challenges. This Essay thus sheds critical new light on how a central bank can best use its 1. See, e.g., Charles F. Sabel & William H. Simon, Minimalism and Experimentalism in the Administrative State, 100 Geo. L.J. 53, 78 (2011) (identifying "continuous