eFinancialCareers

What is it?

The Federal Reserve is the central bank for the United States. Rather than being one single bank, it is in fact 12 different banks located in the country’s major cities. At its head sits the Chairman of the Board of Governors of the Federal Reserve System, currently Ben Bernanke.

Although there are a dozen Federal Reserve banks in total, the one most frequently referred to is the Federal Reserve Bank of New York. The New York Fed takes a lead role in determining money supply and interest rates (via the discount window) and is therefore far more important than the other 11.

Aside from setting interest rates and determining money supply, the Fed’s key historical purpose has been to ensure US commercial banks have sufficient capital adequacy to meet their operating requirements. The Federal Reserve System also acts as the government’s banker – processing incoming taxes and making outgoing payments – and issues US dollars.

What’s it got to do with the financial crisis?

The Federal Reserve is at the forefront of the battle to keep the global financial system afloat.

As US financial institutions like Bear Stearns, IndyMac, Fannie Mae and Freddie Mac, and AIG have buckled – or shown signs of buckling – under the force of the credit crunch, the Federal Reserve has been forced to come to the rescue.

In the case of Bear Stearns, it helped engineer a rescue via JPMorgan. JPMorgan borrowed money from the discount window to help finance Bear Stearns. At that point, pure investment banks like Bear weren’t allowed to borrow from the discount window, but commercial banks like JPMorgan were.

Since then, the Fed has made several momentous moves. These include the establishment of:

• The Primary Dealer Credit Facility (PDCF): Created at the time of Bear Stearns' blow-up in March 2008, the PDCF allows investment banks to swap ‘investment grade’ assets (ie, assets considered to be non-risky by ratings agencies, including top-rated asset backed securities) for cash on an overnight basis. The establishment of the PDCF marked the first time that investment banks had been allowed to borrow at the discount window since the 1930s. When it was created in March, the Fed said the PDCF would be open for six months. However, in June 2008 it indicated that the facility would remain open for as long as banks remain distressed.

• The Term Auction Facility (TAF): A new facility, set up in December 2007, through which the Fed auctions cash to banks for periods of up to 85 days (as of October 2008) in return for toxic assets such as AAA rated mortgage backed securities and AAA rated CDOs. When it was launched, the TAF involved two $20bn auctions, one for 28 days and one for 30 days. Since then, it’s got bigger. Faced with meltdown in the money markets, the Fed massively increased the size of the TAF from $150bn in September 2008 to $900bn in October 2008. Unlike the discount window and the PDCF, the TAF allows banks to borrow money long term.

• The Commercial Paper Funding Facility (CPFF): Another new facility, set up in October 2008, the CPFF allows the Fed to bypass banks and lend money directly to American companies. Under the CPFF, the Fed can buy up so-called ‘commercial paper’, or IOUs issued by big businesses. Commercial paper is one of the financial instruments traded very short term in the money markets. The Fed was forced to set up the CPFF because investors’ appetite for commercial paper had dried up. Companies couldn’t access crucial funding and meltdown was a possibility.

Other audacious moves by the Fed include:

• Opening the discount window to Fannie Mae and Freddie Mac – before the US government took them into 'conservatorship' in early September 2008.

• Failing to lend money to collapsing investment bank Lehman Brothers, but lending $85bn to struggling insurance firm AIG, for fear that its collapse would jeopardise the entire financial system.

• Providing a new $500bn money market funds and put cash back into the money market system.

The Fed also pumped billions of dollars of additional money into the global financial system. The additional liquidity was aimed at bringing down the LIBOR rate, which doubled as banks refuse to lend to each other. Despite the Fed’s best efforts, LIBOR remained stubbornly high, but showed signs of Return to A-Z home page