Ford–Levy Institute Projects

This monograph is part of the Levy Institute’s Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, a two-year project funded by the Ford Foundation.

In the current financial crisis, the United States has relied on two primary methods of extending the government safety net: a stimulus package approved and budgeted by Congress, and a massive and unprecedented response by the Federal Reserve in the fulfillment of its lender-of-last-resort function. This monograph examines the benefits and drawbacks of each method, focusing on questions of accountability, democratic governance and transparency, and mission consistency. The aim is to explore the possibility of reform that would place more responsibility for provision of a safety net on Congress, with a smaller role to be played by the Fed, not only enhancing accountability but also allowing the Fed to focus more closely on its proper mission.

The extraordinary scope and magnitude of the financial crisis of 2007–09 required an extraordinary response by the Federal Reserve in the fulfillment of its lender-of-last-resort (LOLR) function. In an attempt to stabilize financial markets during the worst financial crisis since the Great Crash of 1929, the Fed engaged in loans, guarantees, and outright purchases of financial assets that were not only unprecedented, but cumulatively amounted to over twice current US GDP as well. the purpose of this brief is to provide a descriptive account of the Fed's response to the recent crisis—to delineate the essential characteristics and logistical specifics of the veritable "alphabet soup" of LOLR machinery rolled out to save the world financial system. It represents the most comprehensive investigation of the raw data to date, one that draws on three discrete measures: the peak outstanding commitment at a given point in time; the total peak flow of commitments (loans plus asset purchases), which helps identify periods of maximum financial system distress; and, finally, the total amouunt of loans and asset purchases made between January 2007 and March 2012. This third number, which is a cumulative measure, reveals that the total Fed response exceeded $29 trillion. Providing this account from such varying angles is a necessary first step in any attempt to fully understand the actions of the central bank in this critical period—and a prerequisite for thinking about how to shape policy for future crises.

Motives, Countermeasures, and the Dodd-Frank Response

Government forbearance, support, and bailouts of banks and other financial institutions deemed “too big to fail” (TBTF) are widely recognized as encouraging large companies to take excessive risk, placing smaller ones at a competitive disadvantage and influencing banks in general to grow inefficiently to a “protected” size and complexity. During periods of financial stress, with bailouts under way, government officials have promised “never again.” During periods of financial stability and economic growth, they have sanctioned large-bank growth by merger and ignored the ongoing competitive imbalance.

Repeated efforts to do away with TBTF practices over the last several decades have been unsuccessful. Congress has typically found the underlying problem to be inadequate regulation and/or supervision that has permitted important financial companies to undertake excessive risk. It has responded by strengthening regulation and supervision. Others have located the underlying problem in inadequate regulators, suggesting the need for modifying the incentives that motivate their behavior. A third explanation is that TBTF practices reflect the government’s perception that large financial firms serve a public interest—they constitute a “national resource” to be preserved. In this case, a structural solution would be necessary. Breakups of the largest financial firms would distribute the “public interest” among a larger group than the handful that currently hold a disproportionate concentration of financial resources.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 constitutes the most recent effort to eliminate TBTF practices. Its principal focus is on the extension and augmentation of regulation and supervision, which it envisions as preventing excessive risk taking by large financial companies; Congress has again found the cause for TBTF practices in the inadequacy of regulation and supervision. There is no indication that Congress has given any credence to the contention that regulatory motivations have been at fault. Finally, Dodd-Frank eschews a structural solution, leaving the largest financial companies intact and bank regulatory agencies still with extensive discretion in passing on large bank mergers. As a result, the elimination of TBTF will remain problematic for years to come.

The extraordinary scope and magnitude of the financial crisis of 2007–09 induced an extraordinary response by the Federal Reserve in the fulfillment of its lender-of-last-resort function. Estimates of the total amount of bailout funding provided by the Fed have ranged from its own lowball claim of $1.2 trillion to Bloomberg’s estimate of $7.7 trillion (just for the biggest banks) to the GAO tally of $16 trillion. But new research conducted as part of a Ford Foundation project directed by Senior Scholar L. Randall Wray finds that the Fed’s commitments—in the form of loans and asset purchases to prop up the global financial system—far exceeded even the highest estimates.

 

There have been a number of estimates of the total amount of funding provided by the Federal Reserve to bail out the financial system. For example, Bloomberg recently claimed that the cumulative commitment by the Fed (this includes asset purchases plus lending) was $7.77 trillion. As part of the Ford Foundation project “A Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis,” Nicola Matthews and James Felkerson have undertaken an examination of the data on the Fed’s bailout of the financial system—the most comprehensive investigation of the raw data to date. This working paper is the first in a series that will report the results of this investigation.

The purpose of this paper is to provide a descriptive account of the Fed’s extraordinary response to the recent financial crisis. It begins with a brief summary of the methodology, then outlines the unconventional facilities and programs aimed at stabilizing the existing financial structure. The paper concludes with a summary of the scope and magnitude of the Fed’s crisis response. The bottom line: a Federal Reserve bailout commitment in excess of $29 trillion.