The Federal Reserve Bank of New York recently released a study entitled, "The Federal Reserve's Commercial Paper Funding Facility," in a forthcoming "Economic Policy Review. The bank's release says of The Federal Reserve's Commercial Paper Funding Facility, "Established in the wake of Lehman Brothers' bankruptcy to stabilize severe disruptions in the commercial paper market, the Commercial Paper Funding Facility (CPFF) allowed the Federal Reserve to act as a lender of last resort for issuers of commercial paper, thereby effectively addressing temporary liquidity distortions and alleviating the severe funding stress that threatened to further exacerbate the financial crisis. In doing so, the CPFF can be considered a noteworthy model of liquidity provision in a market-based financial system, where maturity transformation occurs outside of the commercial banking sector. Authored by Tobias Adrian, Karin Kimbrough and Dina Marchioni, this paper examines the creation and performance of the CPFF, while simultaneously outlining the evolution and importance of the commercial paper market before and during the CPFF (which expired February 1, 2010)."
The release continues, "Supported by in-depth analysis, detailed data and first-hand accounts, this paper offers a complete overview of the CPFF, including the economic role of the commercial paper market, the events preceding the creation of the facility, operational details of the CPFF and the economics of the facility in the context of the financial system and in relation to the Federal Reserve's role as lender of last resort. As explained by the authors, the careful operational design of the CPFF permitted the Federal Reserve to effectively relieve temporary stress in the commercial paper market while protecting itself from any credit loss. Moreover, the facility's ability to provide liquidity to a particular market as opposed to a particular set of institutions allowed the Federal Reserve to extend its reach beyond depository institutions, a critical factor given the primacy of institutions without discount window access in the commercial paper market."
It says, "Fashioned as a market-based liquidity facility that naturally wound down as the private sector regained its footing, the CPFF serves as a guide for providing emergency backstop liquidity to modern financial markets, where 'the shadow banking system' accounts for a quantitatively and economically important share of the activity. Additionally, while the public sector's role in providing backstop liquidity to the shadow banking system will continue to be debated, the CPFF's successful design could serve as a guide for future policy discussions about reducing the vulnerability of markets to liquidity crises."
The paper's "Conclusion says, "The legal basis for the CPFF stemmed from section 13(3) of the Federal Reserve Act, requiring the use of such a facility in 'unusual and exigent circumstances.' As such, the Federal Reserve does not have the authority to make the CPFF a permanent liquidity backstop. This in turn has implications for the ongoing debate on regulatory reform. The financial market crisis of 2007-09 demonstrated the current financial architecture's vulnerabilities to liquidity crises emanating from nondepository institutions. As such, an important component of regulatory reform focuses on improving the resiliency of money markets to financial and economic shocks. Many ongoing reform efforts aim to reduce the vulnerability of money markets to liquidity crises. These efforts focus particularly on reforming money market funds, the commercial paper market, and the repo markets."
It continues, "It has long been understood that the public sector plays a crucial role in the provision of liquidity. In times of aggregate liquidity shortages, only the monetary authority can act as lender of last resort, owing to its ability to create money. Traditionally, the lender of last resort has been available only to depository institutions because the vast majority of maturity and liquidity transformation took place in those institutions. Since the mid-1980s, however, the rapid growth of a market-based system of credit formation has allowed for maturity transformation by a wide range of institutions, including money market funds, finance companies, and securities broker-dealers, and through a range of market instruments, such as asset-backed commercial paper and tri-party repo."
Finally, the paper says, "Despite the recent crisis, it seems likely that large amounts of maturity and liquidity transformation will continue to be conducted outside of depository institutions -- and therefore without access to the traditional lender of last resort -- in what is known as 'the shadow banking system.' The public sector's role in providing backstop liquidity to the shadow banking system will continue to be debated. Although the duration of the CPFF was necessarily limited, the facility provides a model for a market-based lender-of-last-resort liquidity backstop, which could serve as a guide for future policy discussion."
