Where was the Fed?

B&B, The Book: Chapter 2

This is a draft of chapter two from my book, on the role of the Fed in our banking system.. This chapter was preceded by an exploration of the business of depository lending banks and will be followed by two more chapters on the US banking system, one on the Global Financial Crisis and one on Silicon Valley Bank. Subsequent sections of the book will address insurance and investment management, corporate finance and personal finance. This book is intended for college students (and others) new to the study of finance, hopefully with some interesting material for more advanced readers as well. I welcome and encourage any comments which readers might wish to share. Thanks for reading!

In chapter one, we examined the business of banking through the lens of the bank run scene from the Christmas classic film It’s a Wonderful Life. In that scene, we saw the panicked customers of the Bailey Building & Loan rushing en masse to withdraw their savings from the BB&L in the wake of a run on the cross-town commercial bank, only to find that the BB&L was also short on cash. This was of course a fictional story about a small-town bank somewhere in New York during the 1930s, but bank runs like this were in fact a common occurrence in the United States for much of the nineteenth and early twentieth centuries, culminating in the collapse of over 9,000 banks in the early years of the Great Depression.

In considering how it is that banks work and sometimes fail, we came to understand that banking can be a profitable but inherently unstable business in which effective risk management plays a critical role. When an individual bank fails, however, it is not only the customers, creditors and shareholders of the failed bank who suffer; bank runs have the potential to create very real contagion effects and can trigger runs on other banks, in some cases causing disruption to the broader banking system and to the economy. As a result, banking has over time become a more heavily regulated business, with the Federal Reserve now playing a central role.

But this wasn’t always the case and it seems reasonable to ask: Where was the Fed when thousands of banks failed in the 1930s? What lessons might the Fed have learned from that experience which inform the way it operates today? And for that matter, what exactly is the Fed and what role does it play in our contemporary banking system?

Let’s explore.

Revisiting the BB&L Bank Run. Each year in my Financial Services course, we devote our first class session to studying the Bailey Building & Loan and attempting to understand the BB&L’s basic business model and the inherent risks which the bank must manage, subjects we also discussed in chapter one of this book. But that that discussion typically leaves unanswered (and often unasked) a number of related questions. What risk management mistakes (if any) did the BB&L make which left it unable to meet the withdrawal demands of its customers? How might the existence of deposit insurance available to the BB&L have changed this picture? And why didn’t the Fed (or some other government agency) come to the rescue of the BB&L, as we have witnessed in our more recent financial history?

The BB&L’s Liquidity Problem. One need not be a financial expert to question the wisdom of leaving Uncle Billy in charge of the bank’s cash, even for a few days. As you may recall from the film, Uncle Billy was unusually forgetful and he apparently liked to drink from time to time, even while on the job. A bad memory and a tendency to tipple are not exactly the personal characteristics one would typically look for in the cash manager of a well-run bank, even a small-town building and loan. But as things turned out, Uncle Billy’s drinking was not the only ‘liquidity’ problem at the Bailey Building & Loan.

But why didn’t the BB&L have sufficient liquidity to meet the withdrawal demands of its customers? There were several reasons for this, both on the asset side of the BB&L’s balance sheet and on the liability side. As you will recall from the film, on the morning of the run Uncle Billy turned over all of the BB&L’s vault cash (an asset of the bank)) to the failing cross-town commercial bank, which had unexpectedly called in its loan to the BB&L (a liability of the BB&L). By turning over all of its cash to the cross-town bank, the BB&L was left with insufficient funds to transact even a normal day’s customer business, let alone to meet any unusual withdrawal requests by its customers. And once the cross-town bank was out of the picture as a lender, the BB&L apparently did not have ready access to any other available funding sources of the type we often take for granted in our contemporary banking system, other than George and Mary’s personal honeymoon funds.

The other problem of course, is that many of the BB&L’s customers attempted at the same time to withdraw a large portion of their collective savings—what we call a ‘run’ on the bank—most likely in a panicked response to the failure of the cross-town bank. And these extraordinary customer withdrawal requests would likely have been a problem for the BB&L even if Uncle Billy had not turned over to the cross-town bank all of the BB&L’s vault cash (“every last cent”). As we learned in chapter one, no bank holds all of its customer deposits as cash reserves; this is simply not how our ‘fractional reserve’ banking system works. But no banker in his right mind would do what Uncle Billy did on the morning of the run, and certainly not in the wake of the failure of the only other bank in town.

For any bank to be successful over a long period of time, it must generate profits for its shareholders, which it does by making loans to its borrower customers and earning a rate of interest higher than the rate it pays to its depositors and other funding sources. Some of this profit will periodically be returned to the bank’s shareholders in the form of dividends, but most of it will be retained by the bank, increasing its shareholders equity and providing the bank with additional ‘capital’ to support future growth. To remain open for business, however, the bank must do more than generate profits and grow its capital base; the bank must also operate at all times with sufficient access to cash (liquidity) in order to meet the redemption and repayment demands of its creditors, whenever these debts come due (even unexpectedly). It may take months or even years for an unprofitable bank to reach the point of capital insolvency, but a bank whose liquidity is called into question can sometimes fail in a matter of days (or hours) in the event of a run and in the absence of emergency funding support.

And this is exactly what happened to the BB&L and the cross-town Bedford Falls commercial bank, as well as to thousands of very real banks during the early 1930s.

Deposit insurance. Deposit insurance is an important feature of our contemporary banking system which has substantially reduced the frequency and severity of bank runs and which as a result we often take for granted. In the United States today, virtually every commercial bank in the country benefits from deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC), a government-sponsored entity which operates an industry-financed deposit insurance fund which will pay off depositors at insured banks in the event of bank failures up to FDIC coverage limits. By virtue of this FDIC guarantee, fully-insured depositors have little incentive to engage in a run on the bank, even at a failing bank. And by reducing the incentive for depositors to run, FDIC insurance itself enhances the liquidity of participating banks and of the entire banking system, allowing banks to hold less cash and other liquid assets in reserve and to expand the amount of credit available across the banking system.

So why didn’t the Bailey Building & Loan and the cross-town commercial bank have deposit insurance, which would presumably have mitigated the risk of a run by their customers? The most obvious answer, of course, is that the fictional bank run scene from It’s a Wonderful Life was set in the early 1930s, shortly before the launch of federal deposit insurance and long after the expiration of New York State’s own deposit insurance program (which ended in 1866). The FDIC began operation in 1934, following passage of the Banking Act of 1933, and initially insured depositors against loss up to an amount of $2,500 per depositor (roughly $60,000 in today’s dollars). This new program of federal deposit insurance was quite controversial at the time—the banking industry lobbied strongly against it and FDR himself was initially opposed—but deposit insurance proved to be an exceptionally popular and quite effective government program. Within a year, 90% of all US commercial banks had enrolled in the new FDIC program and the widespread bank runs experienced during the early 1930s came largely to a halt.

But there is another possible reason why the BB&L might not have had federal deposit insurance program, even after 1934. As you will recall from chapter one, the BB&L was not technically a commercial bank whose customers held ‘demand deposits’, ie deposits which become immediately due and payable by the bank on the demand of its customers. It was instead a mutual savings bank whose customers owned ‘shares’ in the bank, and by the terms of their share contracts the BB&L’s customers could only cash out their shares and close their accounts after giving the bank 60-days advance notice, providing the bank with time to come up with the cash needed to redeem the shares, as George Bailey attempted without success to explain to his own customer-shareholders.

In part because of this restriction on shareholder redemptions, which was a common feature of mutual savings banks at the time (and still is today), run risk was considered to be less of a problem at savings banks than at commercial banks. Savings banks also tended to be less aggressive lenders than commercial banks, with higher cash reserves and lower credit losses as a result. And so even in 1934, after the biggest commercial bank run in the nation’s history, two-thirds of all US savings banks did not sign up for FDIC insurance. And despite their lack of insurance, relatively few mutual savings banks failed as a result of runs during the Great Depression.

Where was the Fed? Anyone who lived through the Global Financial Crisis in the early 2000s will recall that but for the operation of the Fed as a lender of last resort to banks and other financial institutions, the US financial system might well have collapsed and with it the global economy. In the end we narrowly avoided such a calamity following the Global Financial Crisis, but this was not the case during the 1930s, when the Fed was at best inconsistently responsive to the liquidity needs of the nation’s banks. And the Fed’s failure in this regard turned what might otherwise have been a series of isolated problems at individual banks into a nationwide run on the banking system—culminating in FDR’s famous “bank holiday” temporarily closing all of the nations banks (following similar actions by many states)—exacerbating the unprecedented economic collapse which we now refer to as the Great Depression.

Unlike the FDIC, the Federal Reserve System was in fact up and running in the early 1930’s, having been created by Congress in 1913 in response to a series of increasingly problematic bank runs culminating in the Panic of 1907. The Fed was created by Congress for the stated purpose of enhancing the stability of the US banking system and thereby promoting the uninterrupted flow of credit to support a growing economy. And given this legislative history, one might have expected that by 1930 the Fed would have been better prepared to deal with yet another run on the banking system, which unfortunately proved not to be the case. But why?

Part of the answer seems to be that many US banks at that time were not in fact members of the Federal Reserve System, and so did not benefit directly from Fed support. In 1930, there were something like 8,000 banks which were members of the Fed system (including most large and urban banks), but twice this number of banks were not Fed members (mostly smaller or rural banks) and these non-member banks constituted a disproportionate share of the 9,000 or so banks which failed during the 1930s. But there is more to the story than this, and at least in hindsight it seems clear that the Fed in the 1930s often failed in its fundamental responsibilities to protect the safety and soundness of the US banking system.

In evaluating the Fed’s policy responses to the events of the early 1930s, we should keep in mind that the Fed at that time had more limited legal authority than it does today, both with respect to monetary policy (the US was still on the gold standard) and also in its capacity as lender of last resort (where the Fed was more limited in the type of collateral it could accept from member banks). But even when the Fed did have the legal authority to take emergency action, it often responded cautiously and sometimes inconsistently. For example, a few of the regional Federal Reserve Banks responsible for providing emergency funding to their local banks took an expansive view of the Fed’s responsibilities in this regard, making funds widely available to member and non-member banks, keeping the flow of credit open in their regions. But most of the Regional Banks did not take this path, leaving non-member banks and even some member banks without access to sufficient funding and constraining the availability of credit in their regions. And this determination whether to provide emergency credit, and to whom, was made locally by the Regional Banks and not centrally by the governing Board of the Fed. (We will discuss the organization of the Fed below.)

But whatever the reasons for the Fed’s actions (or inactions) in this regard, the economic consequences were enormous: a 50% fall in industrial production and GDP, 25% unemployment, millions of Americans homeless and the farm economy decimated. And this was just in the United States.

The Great Depression was not solely a US phenomenon, of course, and the responsibility for dealing with it did not lie solely with the Fed or with the US government for that matter. The entire world economy was depressed during these years, in some countries more than in others, and many of the most important events of this period took place outside the United States, often with global ramifications. As an example, Great Britain went off the gold standard in 1931 and devalued its currency by 25%, producing a quick initial economic recovery in Britain and in the other countries which followed suit. But this move also triggered an international run on the US dollar, to which the Fed responded initially by increasing US interest rates in an attempt to defend the dollar’s fixed exchange rate in gold, accelerating the contraction in the domestic economy and worsening the ongoing banking crisis, exactly the opposite approach that the Fed would likely take today (admittedly without the constraint of the gold standard). [Note: The U.S. came off the gold standard for domestic transactions in March 1933, one of FDR’s first moves as president, and ended the international convertibility of the dollar to gold in 1971 under President Richard Nixon, effectively ending the gold standard in the USA.]

In the light of history, it now seems clear that much of the economic carnage of the Great Depression could have been avoided (or mitigated) had the Fed and other policy makers understood then what we understand today about both monetary policy and the provision of liquidity to the banking system. In 2002, several years before the events of the Global Financial Crisis, then Fed governor (but not yet chair) Ben Bernanke spoke at a conference in honor of Milton Friedman, the University of Chicago economist whose academic research documented many of the failings of the Fed in responding to the events of the Great Depression. Bernanke closed his talk with this comment about the Fed’s performance in the 1930s, addressed to Professor Friedman: “You’re right.” said Mr. Bernanke. “We [the Fed] did it [caused the Great Depression]. We’re very sorry. But thanks to you, we won’t do it again.”

And the Fed under chairman Bernanke largely made good on this promise, much sooner and under much worse circumstances than anyone at the time ever expected. Under Bernanke’s leadership, the Fed’s aggressive policy response to the near collapse of the global banking system in the early 2000s was in fact much improved from its more timid response to similar events in the 1930s. And the actions taken by the Fed and other central banks during the Global Financial Crisis, while sometimes flawed and often controversial, almost certainly ensured that we did not suffer another Great Depression as a result.

We will explore the Global Financial Crisis in more detail in chapter three, but before we go there it would perhaps be helpful to learn a bit more about the Fed, widely regarded as the most important financial institution in the world.

What is the Fed? When we talk about “the Fed” we are generally referring to the Federal Reserve System, or some branch of it, which is the “central bank” of the United States. For much of our history, however, the US operated without a functioning central bank, until the Federal Reserve System was established in 1913. Today the Fed plays a critical role in US macro-economic management and in responding to financial crises, as well as in the regulation and supervision of banks and bank holding companies. And yet the Fed is not well understood by much of the American public, despite its manifest importance to our economy and to our country.

Central banks are government entities, not private sector banks, and their specific responsibilities vary from country to country. Here in the United States, most people know of the Fed for its role in setting interest rates and regulating macro-economic activity, a topic which often features prominently in the media and in the halls of Congress. But the Fed does many other important things as well. As we have seen, it acts as the lender of last resort to the US banking system, which gives it an important role not only in responding to financial crises but in preventing them. The Fed is the primary regulator and supervisor of the largest US banks and bank holding companies, acting in concert with other government agencies and in some cases with regulators outside the United States. The Fed acts as a ‘bankers’ banker’ to the nation’s commercial banks, who place their reserve funds on deposit with the Fed, and to the US Treasury, whose disbursements are made out of the UST’s operational account at the Fed. The Fed provides various services which facilitate US dollar transactions and payments and contribute to the smooth operation of our nation’s financial plumbing. And the Fed collects and publishes economic and financial data, engages in related economic research, and actively promotes the public understanding of economics and finance.

How is the Fed organized and governed? As noted, the Fed was established by act of Congress in 1913, in response to a series of financial crises culminating in the Panic of 1907. In establishing the Fed, Congress rejected the concept of a single central bank entity under the complete control of the federal government, and instead provided for a central banking system including a Board of Governors under government control and twelve regional Reserve Banks with a hybrid public-private governance structure. For our purposes, the most important Fed entities are the Board of Governors, the Federal Open Market Committee and the twelve regional Reserve Banks, of which the primus inter pares is the Federal Reserve Bank of New York.

The principal governing arm of the Fed is the Board of Governors, which consists of seven governors appointed by the president and confirmed by the Senate, including the highly visible chairman of the Board. Governors serve 14-year staggered terms; the chairman and vice-chairman are appointed to four-year terms and may be reappointed subject to term limitations. All seven members of the Board of Governors are voting members of the Federal Open Market Committee (FOMC), the entity which conducts monetary policy, along with five of the twelve regional Reserve Bank presidents. The president of the Reserve Bank of New York is a permanent voting member of the FOMC, in recognition of the special role played by the NY Fed in implementing monetary policy through its ‘open market’ operations, with the other four seats filled on a rotating basis by the presidents of the other regional Reserve Banks.

As an agency of the federal government, the Fed Board reports to and is directly accountable to Congress. Board members are called to testify before Congress and they periodically communicate with other government entities as well. The Fed chair reports to Congress twice a year on the Fed's monetary policy objectives, testifies on numerous other issues and meets with the Secretary of the Treasury. While the Fed has frequent communications with executive branch and congressional officials, its decisions are made independently, and this tradition of ‘Fed independence’ is regarded as particularly important in the area of monetary policy, protecting the Fed’s decision-making from undue partisan political interference. And yes, the Fed is audited, regularly and at various levels.

What are the central missions and principal policy tools of the Fed? As explained by Ben Bernanke in his book The Federal Reserve and the Financial Crisis (2011), the Fed has two central missions: (i)) to promote macro-economic stability and growth, consistent with stable prices and full employment; and (ii) to promote financial stability, most notably with respect to the commercial banking system. Both of these missions have been part of the Fed’s charter since its establishment in 1913, but have evolved significantly over the years. The Fed has three principal policy tools which it uses to promote its central missions, discussed further below: (i) monetary policy, most notably through the the setting of interest rate targets; (ii) liquidity provisioning, acting as lender of resort to banks and sometimes other financial institutions; and (iii) bank regulation and supervision, a responsibility it shares with other government agencies and entities including the FDIC.

Monetary policy. The Fed (and specifically the FOMC) is responsible for setting US monetary policy, the government’s policy relating to the supply and cost of money and credit circulating in the economy. When the level of US macro-economic activity is deemed to be sub-optimal, with too little GDP growth or less than full employment, the Fed may elect to ‘ease’ monetary policy by lowering interest rates in an effort to stimulate more economic activity. And when the level of macro-economic activity is deemed to be excessive, with overly tight labor markets or above-target rates of inflation, the Fed may elect to ‘contract’ monetary policy by raising interest rates in an effort to slow down the pace of economic activity. In these cases, the Fed is exercising its monetary policy authority to influence the level of activity in the overall economy, consistent with its mission to promote macro-economic stability and growth.

And so for example we saw that in the wake of the Global Financial Crisis, with the US economy in deep recession, the Fed cut interest rates effectively to zero and kept them at this level for close to a decade in an attempt to stimulate macro-economic policy. And during the covid shutdowns in 2020, the Fed cut rates again for the same reason, before reversing course two years later and raising rates aggressively in an attempt to combat a nasty bout of post-covid inflation.

For our purposes, we don’t need to go into great detail on the mechanics of monetary policy, but we should perhaps comment on just a few aspects of monetary policy which frequently come up in public discourse but which are not always well understood.

First, it is important to understand that the Fed does not ‘control’ the level of interest rates prevailing in the economy, for example the interest rates on bank deposits, credit card loans or residential home mortgages. The Fed has significant influence over some of these rates, and less over others, but it does not have absolute control over any of them. When the Fed (or FOMC) adopts a new interest rate target, what it is really doing is attempting to influence the cost of funding for the nation’s banks, in the expectation that the desired changes in the banks’ cost of funds will filter through to the rate of interest paid by other borrowers throughout the economy.

On a somewhat more technical note, the so-called ‘policy rate’ set by the FOMC refers to the “federal funds rate”, the rate of interest applicable to overnight inter-bank lending of excess reserves held on deposit at the Fed. (Banks which want to expand their lending activity may find that they need more reserves to support this lending than they currently have, and so they may need to borrow excess reserves from other banks, which they can do in the fed funds market.) The actual rate of interest prevailing in the fed funds market is set by the transacting banks themselves, not by the Fed, but the Fed does control certain other ‘administered rates’ which effectively set a floor and a ceiling on the rate at which banks will borrow or lend their excess reserves. These administered rates include the rate of interest paid on bank reserves held on deposit at the Fed, the interest rate paid to financial institutions who lend to the Fed on a secured basis in the ‘repo’ market, and the rate of interest charged to banks who borrow at the Fed ‘discount window’ (the Fed’s primary vehicle for providing emergency funds to the banking system, discussed further below). And on occasion the Fed also intervenes in the market for short-term government securities, through its so-called ‘open market operations’, in an attempt to further influence the effective fed funds rate.

Second, the Fed has much less influence on longer-term interest rates than it does on short-term rates. The interest rate on longer-term loans and securities will of course bear some relationship to the current level of short-term rates, but this relationship between short and longer-term rates—what academics refer to as the “term structure of interest rates” and finance professionals refer to as the “yield curve”—is far from stable. We typically expect that the interest rate or yield on longer-term loans and securities will be higher than the prevailing rate on shorter-term debt instruments, compensating lenders (and investors) for the greater amount of interest rate risk on longer-term debt. But this is not always the case. In normal times, the yield curve may be ‘positively sloped’ (with longer-term rates higher than shorter-term rates), but sometimes the yield curve is ‘flat’ (with short and longer-term rates roughly equal), sometimes it is ‘inverted’ (with short rates higher than long rates), and sometimes it is ‘kinked’ (for example with medium-term rates above or below both shorter and longer-term rates).

The rate of interest charged on longer-term debt is often more important than short-term rates for certain types of economic activity, for example in the housing market where the interest rate on a 30-year mortgage may be more relevant than the rate currently paid on bank deposits. And when the Fed feels the need to push up or down the cost of longer-term credit, it may sometimes have to do more than simply nudge up or down the cost of short-term funding for commercial banks. During the Global Financial Crisis, for example, the Fed had already forced short-term rates down close to 0%, but long rates stayed higher than the Fed deemed optimal. And so the Fed (along with many other central banks) embarked on an aggressive program of “quantitative easing”, purchasing trillions of dollars of longer-term debt securities held in the investment portfolios of banks and other financial institutions in an attempt to drive down the prevailing level of longer-term interest rates and thereby further stimulate the economy. These central bank ‘QE’ programs were quite controversial at the time, and it is unclear even today how effective they really were.

Third, one often hears it said that the Fed has been “printing money”, which is usually intended as a criticism of expansionary Fed monetary policy, as we saw for example during the Global Financial Crisis and again during Covid. Depending on the context, this comment may be metaphorically true but it is not literally true, at least not in the way that some people seem to understand it, if by ‘money’ what they really mean is ‘currency’.

In the United States, coins are produced by the US Mint and paper currency is printed by the Treasury Department’s Bureau of Engraving and Printing, and the Fed does not control the production of either. The Fed does however play an important role in determining the amount of ‘money’ circulating in the economy, of which ‘currency’ (coins and bills) accounts for only small portion. But even here the Fed is not in full control. When the Fed buys government securities from the banking system through its ‘open market’ or ‘quantitative easing’ operations—both ways in which the Fed attempts to expand the money supply—it pays for these purchases with newly created central bank ‘reserves’ credited to the selling banks’ accounts at the Fed. In a very real sense the Fed has created these reserves out of whole cloth, and it is not constrained in the amount of such reserves it can create, which lends credence to the widespread observation that the Fed has been “printing money” and sometimes seems to be doing so hand over fist.

But even this is not quite right, and it is important to understand why. Central bank ‘reserves’ are not ‘money’, ie transactional deposits which can be used to pay for goods and services in the real economy. And these newly created reserves held in the banks’ accounts at the Fed do not become money until they are subsequently lent out by the banks to their customers, who can then use the newly created demand deposits to pay for goods and services or to make investments. And it is only at this point, when the banks lend out (or reinvest) their newly created reserves, that the Fed-created bank reserves actually become money and begin to circulate in the real economy, expanding the money supply and stimulating economic activity (and under certain circumstances inflation).

In the years following the Global Financial Crisis, banks largely held on to their newly created reserves at the Fed rather than lending the funds out to customers, due to perceived weak loan demand and ongoing credit concerns. And the banks’ collective decisions in this regard contributed to the slow growth of the economy and the restrained level of prices for a decade, a quite different picture than we saw in the years immediately following the covid pandemic, when supply chains remained constrained but credit expanded, the economy boomed and prices went through the roof.

And so we see that the commercial banking system itself is an important partner with the Fed in the money creation process, an observation which has important implications for the overall regulatory role of the Fed and the ways in which it responds to financial crises.

Lender of last resort. The Fed’s next-most important activity, behind monetary policy, is probably its role as “lender of last resort” to the banking system and in some cases to the financial system more broadly. In times of financial dislocation, the Fed stands ready, willing and able to provide solvent commercial banks with emergency access to short-term funding, enabling the banks to continue providing credit to their own customers and mitigating credit-related disruptions to the overall economy. We observed this most dramatically during the Global Financial Crisis of the early 2000s, when the Fed and other central banks across the world lent trillions of dollars on an emergency basis to banks and other financial institutions, providing the financial system with desperately needed liquidity when the private funding markets had largely shut down.

The Fed’s primary vehicle for providing liquidity to cash-strapped banks is through its so-called “discount window”, where the Fed regularly makes short-term loans to banks facing liquidity constraints. These emergency loans from the Fed are secured by the pledge of eligible collateral, including securities and loans, which provides the Fed with additional credit protection and enables the banks to avoid selling their assets at inopportune times. And because these discount window loans are made at (slightly) above-market rates of interest, the borrowing banks are incentivized to repay the loans as soon as their access to private market funding improves, which is in fact what usually happens.

During the Global Financial Crisis, however, traditional discount window lending proved to be insufficient to meet the unprecedented liquidity challenges facing the entire financial system, and not just commercial banks. And so the Fed not only expanded commercial banks’ access to the discount window, it also implemented a number of new lending programs designed to provide liquidity to a wider variety of financial institutions, utilizing its legal power under Section 13(3) of the Federal Reserve Act, which authorizes the Fed to take such action in “unusual and exigent circumstances”. We will discuss this in more detail in chapter three.

The rationale for emergency lending by central banks was perhaps best articulated by the nineteenth century journalist and editor of The Economist magazine, Walter Bagehot, who in his 1876 book Lombard Street described how the Bank of England came to the rescue of the London money markets following the failure of the discount broker Overend Gurney in 1866. In that book, Bagehot outlined the core principles by which central banks should provide emergency liquidity to the banking system, principles which central bankers still follow today. As summarized in ‘Bagehot’s dictum’, central banks should in appropriate circumstances “lend freely, to solvent banks, against good collateral, and at a penalty rate of interest.” And this is in fact how the contemporary Fed and other central banks approach their activities as lender of last resort, both in normal times and in times of widespread financial instability.

Bank regulation and supervision. The third major policy tool of the Fed—along with monetary policy and liquidity provisioning—is bank regulation and supervision. The Fed is not the only government regulator or supervisor of US banks and for most banks it is not the primary one. But the Fed is the primary regulator and supervisor of the largest US banks and bank holding companies, which control a majority of the total assets in our commercial banking system. And so in this sense at least we can probably say that the Fed is the most important bank regulator in the US, perhaps alongside the FDIC for most smaller banks.

But what exactly is it that bank regulators and supervisors do?

The Fed and other banking regulators draft and implement detailed rules governing various aspects of bank operations which are intended to protect depositors' funds and consumer rights, to ensure that banks operate with sufficient capital and liquidity, and to maintain a stable, efficient and competitive banking system. As banking supervisors, the Fed and other agencies monitor, inspect and examine banks to make sure they are in compliance with the relevant rules and regulations. And for the largest banks and bank holding companies, the Fed supervises periodic ‘stress tests’ to gauge the banks’ likely financial resiliency in times of economic stress, an innovation introduced during the Global Financial Crisis in an effort to reassure the public and the capital markets of the financial soundness of our largest banks.

In addition to the Fed, a number of other federal and state government agencies and entities are also involved in bank regulation. The Office of the Comptroller of the Currency (OCC), an independent bureau of the US Treasury, regulates and supervises nationally chartered banks and savings institutions. Various state agencies regulate state-chartered banks, for example the Department of Financial Services in New York State and the Department of Financial Protection and Innovation in California. The Federal Deposit Insurance Corporation regulates and supervises all national and state banks which participate in the FDIC’s deposit insurance program, which is effectively all commercial banks. The Consumer Financial Protection Bureau (CFPB) implements and enforces federal consumer financial laws applicable to banks, savings and loans and federal credit unions, preempting in this regard some of the regulatory authority of the Federal Trade Commission, which does much the same thing with respect to other types of financial institutions such as mortgage companies and non-bank lenders. And of course banks and bank affiliates are also subject to generally applicable rules and regulations set by non-banking regulators, for example the Department of Labor regulations applicable to financial institutions which manage customers’ retirement funds or more broadly the DOL regulations relating to employment law.

We should also note here that the Fed coordinates many of its regulatory activities (as well as its financial crisis response policies) with those of banking regulators (and central banks) in other countries. A good example is the “Basel Framework” of financial regulations applicable to internationally active banks, adopted by the Basel Committee on Banking Supervision, the primary global standard setter for the prudential regulation of banks. In this context, “prudential regulation’ focuses on the financial safety and stability of banks and other financial institutions and of the broader financial system. This is area in which international coordination is particularly important given the global interconnectedness of banks and financial institutions across the world, something we witnessed big time during the Global Financial Crisis.

The rationale for the Fed’s role in bank regulation (if not supervision) largely follows on directly from the Fed’s congressionally mandated missions to stabilize the macro-economy and the financial system, which it largely implements through monetary policy and by acting as lender of last resort to the banking system. Regulation is the third leg of the Fed’s policy stool, which is intended to enhance the effectiveness of the Fed’s activities and to mitigate the “moral hazard” risks created by the Fed’s role as a standby lender of last resort. In this context, “moral hazard” refers to the phenomenon by which various forms of financial protection—for example deposit insurance or the availability of emergency lending from the Fed—may impact the incentive for banks and other financial institutions to take on more risk than is socially optimal, creating a “heads we win, tails you lose” situation where the profits from risky activities are captured mostly by the banks but some significant portion of the associated costs or losses is borne by third parties, including the taxpayer.

Moral hazard is a major topic in the field of financial regulation, which serves as a good segue to the subject of our next chapter, The Global Financial Crisis, which was in many respects an example of unregulated moral hazard run amok. But this time the Fed and other global policymakers were prepared to respond aggressively and to err on the side of excess rather than caution, a big change from the 1930s.