The Federal Reserve as Last Resort
University of Illinois Urbana-Champaign College of Business
December 19, 2012
University of Michigan Journal of Law Reform, Vol. 46, No. 1, 2012
Notre Dame Legal Studies Paper No. 13-02
The Federal Reserve, the central bank of the United States, is one of the most important and powerful institutions in the world. Surprisingly, legal scholarship hardly pays any attention to the Federal Reserve or to the law structuring and governing its legal authority. This is especially curious given the amount of legal scholarship focused on administrative agencies that do not have anywhere near as critical a domestic and international role as that of the Federal Reserve. At the core of what the Federal Reserve does and should do is to conduct monetary policy so as to safeguard pricing, including that of financial risk.
The recent financial crisis brings the importance of this role into clear resolution, because mispriced financial risk was central to the crisis. To increase the Federal Reserve’s efficacy, recent financial reforms in Dodd-Frank created a new “last-resort” role for the central bank. Ironically, these same reforms threaten the efficacy of the Federal Reserve by increasing “moral hazard,” which could lead to additional mispricing of financial risk.
This Article aims to contribute to legal scholarship focused on the Federal Reserve, an institution whose decisions significantly impact financial markets and much of the rest of the world. In particular, the Article’s first aim is to argue that the Federal Reserve has a new, permanent last-resort role: market-maker of last resort. This new responsibility flows from reforms contained in Dodd-Frank’s Title VIII, which transform and expand the Federal Reserve’s last-resort-lending legal authority. This Article’s second aim is to argue that Title VIII’s market stability-oriented reforms require additional accompanying reforms to counterbalance the moral hazard and related mispricing of financial risk that Title VIII’s reforms could promote. These proposed reforms aim to ensure that the Federal Reserve’s new “last resort” lending role does not inadvertently encourage the excessive risk taking and mispricing of financial risk that brought us the financial crisis and Dodd-Frank in the first place.
Number of Pages in PDF File: 65
Keywords: Federal Reserve, Dodd Frank, Dodd Frank Title VIII, clearing, clearinghouses, central counterparty, credit default swaps, repurchase agreements, market maker of last resort, lender of last resort, central bank, payment clearing and settlement systems
JEL Classification: E50, G20, G21, G10, K20, L50Accepted Paper Series
Date posted: December 20, 2012 ; Last revised: February 4, 2013
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