Emergency lending to banks - Lessons from US banks to save depositors

On 25 January 2024, the Fed, the US Central Bank, announced the termination of its Bank Term Funding Programme with effect from 11 March 2024 (see press release). This is an emergency loan programme implemented on 12 March 2023 to address liquidity pressures that suddenly started hitting banks and financial system unexpectedly. 

The immediate cause of such liquidity pressures was the sudden failure of three banks, i.e., Silicon Valley Bank, Signature Bank and Silvergate Bank, in the second week of March 2023.  In few weeks, pressures spread across First Republic Bank and a large number of regional and community banks due to the diversion of deposits from banks to money markets. 

However, the real cause of this banking turmoil was the sugar high interest rate policy of the Fed that elevated the interest rate risk and liquidity stress across the banking and financial system. Therefore, the Fed opted to continue with high interest policy while printing money to provide emergency funding to banks that were affected by risks of high interest rates. Such money printing to bailout banks was a rational decision as several more billions of new money would not matter, given the four decade high inflationary pressures and pandemic money printing at historic high with 110% increase by mid-2022.

Therefore, this article presents what Sri Lankan authorities should learn from the emergency lending programme of the Fed because banking stability is not a fancy thing as authorities often talk leisurely.

Highlights of the Funding Programme

The programme was launched in terms of section 13(3) of the Federal Reserve Act with a credit insurance support of US$ 25 bn from the Exchange Stabilization Fund of the US Treasury. Its objective was to bolster the capacity of the banking system to safeguard deposits and ensure the ongoing provision of money and credit to the economy without interruption by panic liquidity uncertainties. In central banking, such emergency funding is known as the lender of last resort (LOLR) function.

The LOLR is the only instrument capable of diffusing panic liquidity situations caused by mass withdrawal of funds by panic depositors. As the banking and financial system mainly operate on private book-keeping money with the public trust in its ability to convert into the means of payment or legal tender on face value, such liquidity panics can be resolved only through the LOLR-based money printing. Any delay in LOLR can cause a wide spread banking crisis. The best example is the UK and US banking crisis in 2008/09 caused by the delay in activating the LOLR facility.

Main characteristics of the programme are as follows.

• Eligible depository institutions - All federally insured banks and financial institutions (savings associations and credit unitions) or US branch or agency of foreign banks.

• Eligible collaterals - All securities accepted for Fed's open market operations, i.e., Treasuries, Agency debt and mortgage backed securities and others.

• Loan value - Up to 100% of the face value of collaterals.

• Repayment period - One year. Any pre-settlement is permitted.

• Interest rate - One year overnight index swap rate plus 10 basis points. This was lower than the rate of interest paid by the Fed on bank reserve balances.

• Programme period - Up to 11 March 2024.

Progress of the Programme

• On 16 March 2023, total lending was US$ 11.9 bn. It rose to US$ 129.2 bn on 31 December (see the Table below).

• As of 31 December, Fed's interest income on these loans stood at US$ 4.1 bn.

• In addition, banks accessed the the Fed's discount window and short-term repo facilities (OMO) for additional liquidity. Accordingly, the Fed balance sheet/money printing reported a sudden bump of about US$ 350 bn in March/April 2023 (see the Chart below) against the quantitative tightening followed from early 2022.

Fed's announcement on 24 January 2024

• The Fed stated that the programme helped assure the stability of the banking system and provide support for the economy during the period of stress last spring. 

• Accordingly, it announced the cease of the programme on 11 March 2024 as scheduled whereas after 11 March, banks and other depository institutions would continue to have ready access to the discount window to meet liquidity needs as usual.

• However, interest rate on new loans was revised to not to exceed the Fed's interest rate paid on bank reserve balances which is 5.4% at present. The reason was the arbitrage profit made by banks from borrowing at lower interest rate (e.g., 4.93% reported on 23 January 2024) from the programme and parking funds at reserve accounts with the Fed at higher interest rate (5.4%).

Emergency Lending Provisions in Sri Lanka

Under the Monetary Law Act (MLA), the Central Bank of Sri Lanka (CB) had wide powers to provide emergency funding to banks in periods of imminent financial panic which directly threatens monetary and banking stability. The Monetary Board had the discretion to determine loan amount, collaterals, interest rate, conditions imposed on business of banks borrowing from the facility, etc.

However, the new Central Bank Act certified on 14 September 2023 as part of the conditions and recommendations of the IMF has repealed the MLA including the emergency lending powers. 

The new Act section 36(6) has restricted the emergency lending powers. Accordingly, the CB can grant such loans up to a maximum period of 180 days when financial stability issues are at risk and to avoid a disturbance in the financial system only if a government guarantee is provided to cover losses arising from such emergency lending. Unlike in the MLA, such lending will cover all banks, finance companies and leasing companies. As a result, the LOLR has now become an extended fiscal policy tool of the debt-trapped government. The hidden motive of this unusual restriction for the central bank with financial system stability is not clear.

This new LOLR restriction may be due to its less need in view of the new macroprudential authority given to the CB in the new Act. Accordingly, the CB may be expected to avoid financial system issues or systemic risks at all times through its new macroprudential instruments and powers. As such, CB is the only central bank in the world without LOLR replaced by the macroprudential authority to ensure the system stability.

Important Issues and Lessons

I recall a similar system introduced in 1997 in the UK by removing the bank supervision function from the Bank of England and entrusting the Bank of England with the financial stability under a tri-partite arrangement, i.e., Treasury, Bank of England and Financial Services Authority (FSA). However, the Bank of England miserably failed to secure the stability in 2007/09 crisis (just after a decade of the new system) and the government had to nationalize all banks to rebuild the public trust. In addition, bank supervision was given back to the Bank of England whereas supervision of other financial institutions and markets were left to the FSA as before.

However, the US government never scaled down the supervision of national banks by the Fed and its emergency lending and discount window facilities to all depository institutions. Therefore, the US did not confront any bank runs of UK's Northern Rock style in 2007/09 crisis. However, the Fed urgently launched the emergency lending programme this time as it learned the lesson due to the delay offering such lending in 2007 at the onset of the financial crisis. The Bank of England also launched a special funding programme to address the financial market instability unexpectedly caused by the tax-cut and energy subsidy-based growth model proposed by Liz Truss government in October 2022.

What is important to understand is that banks exist in business because of the depositor trust in banks and moral hazard over bank bailouts by the central bank in the event of liquidity problems. Therefore, banks are managed through rollover of liquidity mostly on a daily basis with the support of inter-bank lending and central bank standing facilities to fill the inter-bank lending gaps. Therefore, this kind of bank liquidity management can prevail only in normal times. 

For example, in recent Sri Lanka, daily overnight inter-bank lending has been mostly below Rs. 10 bn with the CB reverse repo lending (overnight and short0term) ranging from Rs. 20 bn - 150 bn. This how the banking system is able to rollover Rs. 12 trillions of deposits created by bank lending in the economy. Whether bank lending is fairly distributed among the potential growth sectors is a separate issue connected with macroeconomic management model in place.

However, in times of liquidity pressures similar to what was reported in the US in March 2023, inter-bank market ceases to operate and, therefore, central bank standing facilities will not be capable of diffusing such panic liquidity pressures. This is where LOLR type emergency lending has to take its place. Therefore, it will be a big mistake if the central bank believes that its policy rates-based standing facilities or OMO will forestall systemic liquidity crunches. OMO is nothing but lethargic monetary policy that miserably targets inflation whereas banking sector liquidity issues arise from structural weaknesses despite fancy talks of bank risk management and regulations.

Another big mistake is the excessive dependence on fancy macroprudential concepts and tools for the financial system stability. This is only an academic approach to supervision until a crisis is triggered unexpectedly. The European Central Bank operating with all such fancy financial stability tools has recently advised banks to closely monitor social media for early signs of bank runs sources. However, the early detection of bank runs or instabilities is a prime responsibility of central banks who operate on financial stability mandates not second to price stability.

Sri Lankan Emergency Options

In the event of a banking liquidity panic situation which nobody can predict, the government has three options to be aware of the emergency.

• provide the government guarantee for emergency lending whenever the CB wishes to grant loans or

• amend the Central Bank Act overnight to require the CB to offer emergency lending as determined by the Minister of Finance (because it is the Minister who offers the birth certificate to banks) or

• let a banking crisis and hold the Governing Board and Monetary Policy Board responsible for the loss to the economy.

Therefore, we have to wait for the new history to come in few years to know the success of new financial stability tools and how Sri Lankan government will take charge of the banking/financial system stability as the history so far proves that central banks have failed in the job of the system stability.

Relevant authorities must understand consequences of abrupt disruption of systems tested for decades in the country before they disrupt them for whatever reasons.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)