Central bank lending logistics in the war on COVID-19: A primer
Logistics including the quick adaptation of supply chains are critical to a war effort such as the fight against COVID-19. For central banks the basic supply chain is moving money with lightning speed to the correct location. To meet the demands of the battle, central banks are quickly assigning collateral with clear legal rights to the central bank as security for new lending. Frequently pricing the collateral, and assessing its underlying lendable value, is a crucial part of the process.
As is the case of any war, good central bank lending requires effective logistics to win battles in the early part of a financial crisis. When combined with private sector infrastructure and expertise, logistics are a critical foundation to defeating economic and financial crises. To quote President Eisenhower, Supreme Allied Commander in Europe during World War II: “You will not find it difficult to prove that battles, campaigns, and even wars have been won or lost primarily because of logistics.” Following is an explanation of the tools the Fed has been using to deal with the crisis.
The Fed’s nonemergency lending powers: Sections 10b and 14 of the Federal Reserve Act
Section 14 is the Fed’s authority to buy Treasuries and agencies and a form of loan known as a repurchase agreement (repo): a security bought today with an agreement to sell it back on agreed terms in the future. The Open Market Trading Desk (Desk) of the New York Fed relies on Fedwire and the Bank of New York Mellon’s tri-party platform to move money and secure collateral. Pricing of the collateral is easy because it is so liquid, and the Desk holds margin against fluctuations in the price of the collateral to compensate for changes in value if the party receiving cash in the transaction fails. Currently the Desk offers a capacity of well over $600 billion each day. The ramp up in repo volume at the onset of the pandemic was easy as the logistics were already in place.
Section 14 also authorizes swap arrangements that the Federal Reserve enters into with foreign central banks. There is a standing swap network between six major central banks that has been continuously active for almost a decade. The operation involves moving US dollars to a foreign central bank in exchange for its domestic currency at a fixed price. This is the Federal Reserve’s collateral. The foreign central bank is responsible for lending to the private sector and collecting and valuing the collateral. The swap arrangements were extended to nine other countries on March 19, 2020.
Section 10b is the Fed’s authority to lend to depository institutions, commonly known as discount window lending. This section of the Federal Reserve Act does not restrict the eligible collateral as in Section 14 but does limit borrowers to regulated depository institutions. Each of the 12 Reserve Banks has its own discount window. Moving cash is simple: Depository institutions bank with the Reserve Banks, so credits are created in their accounts. They can pledge collateral by filing agreements under the terms of Federal Reserve’s Operating Circular 10. They can pledge securities the same day using standard services such as Fedwire, the Depository Trust Corporation, or EuroClear. Whole loans can be pledged in one business day either directly, by a custodian, or by the borrower in what are known as borrower-in-custody arrangements. Depository institutions price securities internally using various pricing services, and experts at the Federal Reserve determine appropriate haircuts on this collateral to set its lendable value. For whole loans, for example an unsecured loan to a household, the haircuts are applied to the face value of the loan.
As of February 2020, there was $1.6 trillion of lendable value pledged to the 12 Reserve Banks. It is straightforward for depository institutions to pledge more collateral and gain initial access to the discount window. From a logistics standpoint, the discount window is ready for any event at any time.
The Fed’s emergency lending powers: Section 13(3) of the Federal Reserve Act
In the 1930s the US government innovated in many ways to overcome the Great Depression. One innovation, codified in Section 13(3) of the Federal Reserve Act, allows the Fed in times of emergency to conduct discount window lending to a broader set of society than depository institutions. This power to combat the unforeseen was not used again for over 70 years until 2008, when it was used extensively to combat the Global Financial Crisis of 2008–10.
How do lending logistics work for such emergency powers? Two strategies are helpful: build on existing logistics and increase use of private sector logistics. Both strategies ensure that money arrives as quickly as possible. But the first important step is to secure the lending for new counterparties and collateral types, perhaps with private sector assistance.
There is a catch to much of this lending. Federal Reserve Banks by law have to be secured to their satisfaction in their lending activity. Lawyers can argue for a long time about what that means, but it is clear the Fed should not lend when it knows that it will take a credit loss. Guarding against credit loss requires strong legal rights over the collateral and an ability to price it well—standard for central bank logistics in normal times. Federal Reserve lending also usually includes recourse rights: If a borrower fails to return the money, the Fed has legal rights to demand repayment in addition to the collateral. This is why in normal times the Fed lends only to regulated banks at the discount window and has policies for counterparties in open market operations to provide extra protection.
Logistics of two emergency lending facilities
Two examples of facilities that implement the emergency lending logistics strategies laid out above are the Primary Dealer Credit Facility (PDCF) and the Commercial Paper Funding Facility (CPFF) that were announced on March 17, 2020. Both were used in 2008 and have been resurrected for the current crisis.
Famously, the PDCF was up and distributing cash over the span of a weekend following the failure of Bear Stearns in March 2008. How was this possible? The Desk was already using the tri-party platform, and by increasing the range of the collateral priced, margined, and segregated on this platform, it was able to start the new lending facility in a weekend with the primary dealers of the New York Fed. The wires for cash and communication were already in place to the counterparties along with legal agreements for recourse in the event of failure. Boxes 1 and 3 of this New York Fed Current Economics Issues (2009) explain the logistics.
The CPFF involved many new types of counterparties and was unusual in the sense that the Fed, rather than lending against existing assets, was effectively buying primary issuance. Further, commercial paper is unsecured, hence the movement of collateral was not part of the logistics. In order to deal with the novel aspects of the asset class, agents were used for some front, middle, and back office services. The same agents have temporarily been appointed again during the current crisis. The logistics are well described by the text and flow chart of this New York Fed Economic Policy Review (2011) article in section 3.1.
On March 23, 2020, the Federal Reserve announced two new facilities, the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility, to purchase investment grade corporate debt. These facilities will rely on logistics available in the private sector and will have access to the sophisticated risk management system Aladdin. Given the complexity and number of corporate debt securities, such a risk management system will be critical to support logistics.
Good logistics are necessary but not a sufficient condition for victory; one also needs a strategy and good on-the-ground tactics. For regular lending the Fed can build on its logistics with some support from the private sector. For emergency lending, however, even more support from the private sector is required. This will also be the case for ground level tactics.
1. Former army officer Richard Dzina, who in his career at the New York Fed was involved in all the logistics described in this blog post, discussed direct threats to financial system supply chains in this speech in 2018.
2. Also referred to as a haircut later in this blog post.
3. Federal Reserve, European Central Bank, Bank of Japan, Bank of England, Swiss National Bank, and Bank of Canada.
4. On March 31, 2020, the Federal Reserve announced a new temporary facility to provide overnight repo for foreign central banks with accounts at the New York Fed under Section 14. Since foreign central banks have accounts at the Fed, it is very quick and easy to move the money. The foreign central bank’s Treasury collateral is held in custody at the New York Fed. So there is no movement of collateral into the New York Fed, just a temporary reassignment of ownership. The haircuts are determined by the discount window schedule.
5. On April 9, 2020, the Federal Reserve announced three lending facilities, the Paycheck Protection Program Lending Facility, the Main Street New Lending Facility, and the Main Street Expanded Loan Facility that will rely on the logistics of the discount window.
6. Only 123 loans were made under the provisions of Section 13(3) from 1932 to 1936, and thereafter no such cash borrowing took place until the creation of the Primary Dealer Credit Facility (PDCF). See Walker F. Todd, 1993, “FDICIA’s Emergency Liquidity Provisions,” Federal Reserve Bank of Cleveland, Economic Review 29, no. 3 (third quarter): 16-23.
8. Specifically, for investment management, accounting, and custody services.