The Federal Reserve Bank of New York today released The Federal Reserve’s Primary Dealer Credit Facility, the latest article in its series Current Issues in Economics and Finance.
Authors Tobias Adrian, Christopher R. Burke and James J. 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 New York Fed.
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 in which primary dealers 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 would force large numbers of repo market participants to sell their securities, causing the prices of the securities to plummet and prompting lenders to demand even higher “haircuts” to hold these securities as collateral.
In this environment, the Federal Reserve created the PDCF as a backstop facility that makes overnight loans available in exchange for a wide range of collateral. The injection and availability of liquidity 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 expansion of PDCF-eligible collateral to include all securities being financed in the triparty repo market—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 enhance the usefulness of the facility by broadening the types of collateral acceptable for PDCF loans to include less liquid securities and equities.
The authors also address concerns that the PDCF might create “moral hazard”—that the facility, by offering the assurance of back-up financing, will encourage 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.