In “The Federal Reserve’s Primary Dealer Credit Facility” (Current Issues in Economics and Finance, vol. 15, no. 4), authors Tobias Adrian, Christopher Burke, and James McAndrews provide a detailed examination of the conditions that prompted the Federal Reserve to establish an emergency lending facility for primary dealers—banks and securities broker-dealers that trade U.S. government and other securities with market participants and the Federal Reserve Bank of New York.

As the authors explain, the Primary Dealer Credit Facility (PDCF) was created largely to ease liquidity pressures in the “repo market”—the collateralized funding market where primary dealers customarily obtain financing for their securities portfolios—after the near-failure of Bear Stearns in March 2008. Policymakers foresaw a negative chain of consequences in which the breakdown in credit availability in this market would force large numbers of market participants to sell their securities. In turn, this rapid sell-off would cause the prices of the securities to plummet, prompting lenders to demand higher “haircuts,” or risk premia, to hold these securities as collateral.

In this environment, the Federal Reserve created the PDCF as a backstop facility that provides overnight loans in exchange for a wide range of collateral. The injection of liquidity—and the assurance that credit is available—helped arrest the downward spiral in prices and the increases in haircuts. “In practice,” the authors note, “the PDCF allows dealers time to arrange other financing for their assets—for example, by raising equity—or to sell assets at a pace that would not overwhelm the markets and drive securities prices down.”

Adrian, Burke, and McAndrews also examine the Fed’s move to broaden the kinds of collateral acceptable for PDCF loans—a step taken in September 2008, when Lehman Brothers, a major participant in the repo market, appeared headed for bankruptcy. Recognizing that a Lehman bankruptcy would put other financial institutions at risk, including the triparty clearing banks that provide cash and collateral custody accounts for borrowers and lenders in multiple-day repo transactions, the Fed acted to ease funding pressures further by expanding eligible collateral to include less liquid securities and equities.

The authors also address the moral hazard concerns raised by the PDCF—specifically, the notion that by offering the assurance of back-up financing, the facility effectively encourages primary dealers to take excessive risks in managing their funding positions. As Adrian, Burke, and McAndrews note, however, such concerns are offset by the fact that the PDCF protects prudently managed firms from the damaging effects of the risks taken by less responsible firms. In addition, a number of the larger primary dealers have merged with bank holding companies or transformed themselves into bank holding companies since the Bear Stearns episode—a change that gives the Federal Reserve supervisory powers over the dealers it lends to and reduces the likelihood of moral hazard.