Journal of Economic Perspectives—Volume 27, Number 4—Fall 2013—Pages 45–64

The Federal Reserve and Panic

Prevention: The Roles of Financial
Regulation and Lender of Last Resort†

Gary Gorton and Andrew Metrick

A
ny market economy is susceptible to a fundamental mismatch that can
lead to the negative externalities of liquidity demand, which include
credit cycles, bank runs, and financial crises. Assets with liquidity are
“safe” assets. More specifically, “liquidity” refers to the ease with which an asset
can be sold quickly and without a loss of value, in the sense that substantial
sales do not depress the price of this asset nor give rise to an adverse selection
problem in which buyers fear that the asset being sold is of diminished quality.
However, liquidity is hard to produce. Long-term investment is required for
growth, but such investment is by its nature uncertain and costly to evaluate.
On the other side, the ultimate suppliers of investment capital are subject to
liquidity shocks: in particular, at times they will perceive higher risks and desire
greater liquidity, which means holding short-term and very low-risk financial
assets that can easily be sold, like US Treasury bills. In normal times, the maturity
and information mismatch between the long-term investments and short-term
liquidity needs are intermediated by the financial system through the creation
of liquid “money-like” assets. In a simple example, a bank uses bank deposits to
make long-term loans, while promising that the deposits will be available in the
short run. However, a wide array of other short-term financial instruments are

■ Gary Gorton is the Frederick Frank Class of 1954 Professor of Finance and Andrew Metrick
is the Deputy Dean & Michael H. Jordan Professor of Finance and Management, both at
the Yale School of Management, New Haven, Connecticut. Both authors are also Research
Associates, National Bureau of Economic Research, Cambridge, Massachusetts. Their email
addresses are [email protected] and [email protected].
†
To access the disclosure statements, visit
http://dx.doi.org/10.1257/jep.27.4.45 doi=10.1257/jep.27.4.45
46 Journal of Economic Perspectives

also backed by long-term assets, while allowing investors who desire liquidity
to withdraw their funds, or more generally not renew their short-term invest-
ment, in a much shorter time horizon. During a financial crisis, the negative
externalities of liquidity demand are manifested when investors race to withdraw
their liquid assets; in “normal times,” negative externalities occur when each
additional liquid claim does not incorporate in its price its contribution to the
risk of such a crisis.
To mitigate the risk of a liquidity-driven crisis, the United States has a
financial sector safety net with two key pillars: the Federal Reserve as a lender-
of-last-resort and the Federal Deposit Insurance Corporation (FDIC) as a
guarantor of bank deposits. The existence of this safety net then alters the incen-
tives of regulated financial institutions: in particular, they can take greater risks
when their depositors and investors know that this safety net is in place. Thus,
the existence of the safety net provides the rationale for close supervision and
regulations that limit the scope, risk-taking, and leverage of these institutions.
If the safety net is too large, then banks lack incentives to manage risks in a
socially optimal way; if the safety net is too small, then failure of a large institu-
tion could have major spillovers to the whole financial system; and if only the
largest institutions are thus given the most protection, then the private incen-
tives will be for every institution to grow “too big to fail.” This dynamic presents
a complex problem for the Fed as the lender of last resort and regulator of the
largest institutions.
This paper traces the Fed’s attempts to address this problem from its founding.
We will discuss how the effectiveness of the lender-of-last-resort function was eroded
in the 1920s, which in turn contributed to the banking panics of the Great Depres-
sion and indeed has hampered its lender-of-last-resort efforts to the present day. We
consider the regulatory changes of the New Deal, including deposit insurance and
the centralization of Fed decision-making power in the Board of Governors, which
by some combination of luck and design contributed to a quiet period of nearly
50 years in the US financial system. Indeed, during this time bank supervision was
only peripheral to the Fed’s priorities, which moved steadily towards a focus on
price stability using interest-rate policy as its main instrument, and the Fed rarely
needed to even think about the lender-of-last-resort function. The late 1970s saw the
beginning of a transformation of the banking sector, with a rise of nonbank finan-
cial intermediaries and then regulatory adjustments so that banks could compete
with these nonbank firms, which has continued to the present day. The financial
crisis of 2007–2009 shook bank supervision efforts out of their slumber, made the
lender-of-last-resort function central again, and led to a significant shift for the Fed
back to its financial-stability roots. Indeed, the Fed’s efforts in the recent financial
crisis can largely be viewed as attempts to expand the lender-of-last-resort function
beyond its traditional institutions and markets. We conclude by bringing the story to
the present day with a discussion of the evolving role of the Federal Reserve in the
context of the changes under the Dodd–Frank Wall Street Reform and Consumer
Protection Act of 2010.
 Gary Gorton and Andrew Metrick 47

The Establishment of the Federal Reserve System

Market economies will sometimes face a banking panic or financial crisis,

which can be defined as an event in which the holders of short-term debt issued
by intermediaries seek to withdraw cash en masse or refuse to renew their loans.
A crisis is a systemic event; it involves the banking system, not this or that bank. Such a
crisis is an information event (in the sense of Dang, Gorton, and Holmström 2013).
That is, many holders of short-term debt previously viewed it as so safe that it was
unnecessary to gather or process information about the debt, but these debt-holders
then come to fear that the debt is not so safe and that they cannot distinguish good
and bad collateral. In such a crisis situation, when what had seemed safe is no
longer viewed that way, all banks are insolvent in the sense that they cannot honor
their debt contracts without trying to sell assets—and if they try to sell assets, they
will receive only a low fire-sale price, because the value of collateral has become
so uncertain.
In a bank run, holders of banks’ short-term debt come to doubt the collateral
backing the debt. These doubts are not irrational. When no central bank is present,
banking panics occur around the peak of the business cycle when holders of short-
term bank debt receive news that indicates a recession is likely coming (Gorton
1988).1 An unexpected deterioration in macroeconomic fundamentals causes a
shift in expectations. In the ensuing recession, some banks will fail, but it is not
known which banks. Depositors respond by withdrawing their cash from all banks.
In the United States, such panics were common in the century before the start of
the Federal Reserve.
The underlying dilemma in a bank run is that the depositors’ doubts about the
backing collateral can only be removed by showing them cash. But since the banks have
lent the cash out, and the assets of the banking system cannot be sold (except possibly
at low “fire sale” prices), there is no way for the banks to obtain cash except through
a lender of last resort—an institution that lends against the impaired bank collateral.
However, a lender of last resort can only prevent panics if it is sufficiently credible such
that depositors believe it can essentially purchase the assets of the banking system. The
Federal Reserve System was established for exactly this purpose.
At the time the Fed was established, the main perceived defect of the banking
system was that currency was not “elastic”—that is, there was no way to obtain more
currency to meet demands from depositors in times of bank runs, nor to meet
seasonal demands. At that time, the main mechanism for responding to panic was
the private bank clearing houses. Since being established in New York City in 1854,
clearing houses had spread across the country and had become increasingly sophis-
ticated in their responses to crises (for discussion of clearing houses, see Timberlake

1
In the modern era with the presence of central banks, the links between financial crises and recessions
are similar. For example, Demirgüç-Kunt and Detragiache (1998, p. 83) examine the period 1980 –1994
and “find that low GDP growth, excessively high real interest rates, and high inflation significantly
increase the likelihood of systemic problems in our sample.”
48 Journal of Economic Perspectives

1984; Gorton 1984, 1985; Gorton and Mullineaux 1987; Gorton and Huang 2006).
Clearing houses, with one in each large city, were coalitions of member banks.
Ostensibly set up to efficiently clear checks, they assumed a central bank–like role
in crises, even though they were private associations.
A panic would trigger clearing house members to act as one large bank, issuing
special liabilities — clearing house loan certificates —for which they were jointly
responsible. At the outset of the crisis, the clearing house would prohibit the publi-
cation of bank-specific information, which was required during noncrisis times.
Also, the amounts of clearing house loan certificates issued to individual member
banks were kept secret, preventing those banks from being targeted for bank runs.
Following the Panic of 1907, Congress passed the Aldrich–Vreeland Act, which
among other provisions created a system for national banks to issue emergency
“elastic” currency in a panic.
However, these responses of the clearing house member banks were only
triggered by the panic itself. The ability of the clearing houses to issue loan certifi-
cates and Aldrich–Vreeland emergency currency did not prevent panics and their
associated real effects. William Ridgely (1908, p. 173), the US Comptroller of the
Currency from 1901 to 1908, put the issue this way: “The real need is for something
that will prevent panics, not for something that will relieve them; and the only way
to attain this is through the agency of a Governmental bank.”
Thus, the idea behind the establishment of the Federal Reserve System was
that it could do something that the clearing houses and the Aldrich–Vreeland
Act could not do. It could establish a credible emergency mechanism in advance..
When the Federal Reserve System was founded, the main focus was on the potential
benefits of a “bills market”— that is, a market for bankers’ acceptances, which are
a documented promise by a bank to make a payment at a future time. The Federal
Reserve would participate in this market by purchasing bankers’ acceptances. In
addition, banks would be able to use their holdings of commercial paper and other
marketable securities as collateral to borrow at the discount window—thus in effect
exchanging private debt for currency.
Moreover, being a (quasi-)government entity, the Federal Reserve System could
be expected to be solvent and would always be able to lend to banks. By contrast,
the coalitions of clearing house banks might not be solvent, so expectations that the
clearing house would act did not fully deter panics. Indeed, currency premia on
the certified checks, which were joint clearing house liabilities, were positive during
crisis periods (in other words, it took more than $1 of certified checks to buy $1 of
currency), reflecting uncertainty about clearing house solvency. The Aldrich–Vreeland
emergency currency was issued with bank loans as collateral, not US Treasury bonds.
Again, there was uncertainty about the outcomes.
There is an important difference between providing the reassurance that can
prevent bank runs and responding to a crisis once it has happened. Once a finan-
cial event is seen to be systemic and the lender of last resort begins lending, these
actions take time and the process of exchanging private bank assets for government
assets (whether money or Treasury debt) can be costly and painful.
 The Federal Reserve and Panic Prevention 49

It was widely believed that the discounting authority of the Federal Reserve
would prevent banking panics. Banks needing cash could take bankers’ acceptances
(that is, their promise to pay at a near-term date) which were discounted from par
to the Fed’s discount window, where the Fed would buy it at a further discount—
“rediscounting” it. Representative Carter Glass (1927, p. 387), who sponsored the
Federal Reserve Act in the House of Representatives, wrote that the most important
accomplishments of the legislation were to remove “seasonals” in interest rates
and to prevent panics. Senator Robert Owen (1919, p. 99), sponsor of the bill
in the Senate, said that the Federal Reserve Act “gives assurance to the business
men of the country that they never need fear a currency famine. It assures them
absolutely against the danger of financial panic . . .” Congressman Michael Phelan
of Massachusetts, Chairman of the House Committee on Banking and Currency,
argued (as quoted in Hackley 1973, p. 10): “In times of stress, when a bank needs
cash, it can obtain it by a simple process of rediscounting paper with the Federal
reserve [sic] banks. Many a bank will thus be enabled to get relief in time of serious
need.” Businessmen and regulators agreed. Magnus Alexander, the president of the
National Industrial Conference Board announced (quoted in Angly 1931, p. 12)
that “there is no reason why there should be any more panics.” The Comptroller
of the Currency (1915, p. 10) announced that, with the new Federal Reserve Act,
“financial and commercial crises, or ‘panics,’ . . . with their attendant misfortunes
and prostrations, seem to be mathematically impossible.” The Federal Reserve
System’s (1914, p. 17) first Annual Report states that “its duty is not to await emer-
gencies but by anticipation to do what it can to prevent them.”

The 1920s

The establishment of the Federal Reserve System did change the expectations
of depositors about systemic banking crises.2 Gorton (1988) creates a leading indi-
cator of recessions for the earlier US “National Banking Era” from the Civil War
up to 1913, and finds that panics arose when the unexpected component of this
leading indicator of recession exceeded a threshold. During the National Banking
Era, no panic occurred without this threshold being exceeded, and there are no
cases where it was exceeded without a panic. This model predicts that there should
have been a panic in June 1920 (and another panic in December 1929). Thus, the
1920–21 recession can be viewed as the first test of the ability of the Federal Reserve
to prevent bank runs.
As dated by the National Bureau of Economic Research, there was a business
cycle peak in January 1920 and a trough in July 1921. Banks started to fail in 1920;

2
There is some evidence that seasonal swings in short-term interest rates were eliminated, although the
point is controversial. For a sampling of the evidence that the Fed did eliminate seasonal swings, see
Miron (1986) and Mankiw, Miron, and Weil (1987). For the alternative view, see Shiller (1980), Clark
(1986), Fishe and Wohar (1990), and Fishe (1991).
50 Journal of Economic Perspectives

505 banks failed in 1921, and the number of failures continued to rise, averaging
680 per year from 1923 to 1929. The peak was 950 in 1926 (Alston, Grove, and
Wheelock 1994). Hamilton (1985, p. 585) observes that the failed banks were
overwhelmingly small banks in small rural communities: “National banks were only
13 percent of the failures and only 17 percent were members of the Federal Reserve
System.” In other words, for the most part the banks that failed did not have access
to the Federal Reserve discount window.
Though many small banks failed, there was no panic. As many contemporary
commentators noted, depositors did not run on banks. For example, Henry Parker
Willis (1923, p. 1406, emphasis added), who received a PhD in economics from
the University of Chicago and was later the first Secretary of the Federal Reserve
System, wrote:

In previous panics or periods of stringency, difficulty had grown out of the

fact that doubts arose concerning the ability of given institutions to meet
their obligations, owing to the fact that their loans were frozen or that pub-
lic confidence had resulted in withdrawing an undue amount of cash from
them. On such occasions relief was obtained by the banks banding together
for the purpose of supporting any of their number which had sound assets.
In the depression of 1920 –1921, the federal reserve system [sic] was in the
position of a clearing house association, already organized in advance and able
to assist the community . . .

Perhaps predictably, the Federal Reserve Annual Report (1921, p. 99) took a
similar view that the creation of the Federal Reserve had prevented a panic:

Other nations, such as Great Britain and France, with their great central bank-
ing institutions, have always had their years of prosperity and their periods
of depression, although they have been free from the money panics which
we formerly had in this country as a result of our inadequate banking system
and which we would, no doubt, have had in the most aggravated degree a
year or so ago but for the efficiency and stabilizing influence of the Federal
Reserve System.

If bank depositors did not run because they expected banks to have access to the
discount window, then it might not be necessary for banks to have actually borrowed
from the discount window. But in fact, national banks did use the discount window,
as shown in Figure 1. Tallman (2010, p. 104) also notes this use of the discount
window over the years 1914 –27. In 1921, discounts and advances as a proportion
of Federal Reserve credit was at its peak of 82 percent with about 60 percent of
member banks borrowing. “It was not uncommon, evidently, for hundreds of banks
to be continuously borrowing amounts in excess of their capital and surplus” (Shull
1971, p. 37). Notably, there was no evidence that borrowers from the discount
window experienced any particular stigma in credit markets.
 Gary Gorton and Andrew Metrick 51

Figure 1
Federal Reserve Credit Extended, 1917–1935

4
Banker's acceptances
3.5 Discount window borrowing
Government securities held
3 Federal Reserve credit
Billions of US $

2.5

1.5

0.5

0
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19
17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35
Source: Tallman (2010); used with permission.

One reason that banks borrowed so much from the discount window was that
the discount rate was below the market interest rate. During World War I, the Fed
felt that low discount rates were important. “The Board did not believe, during the
war period, that marked advances in rates would be advisable in view of the obvious
necessity of avoiding any policy likely to disturb the financial operations of the Trea-
sury” (Harding 1925, p. 147). During the steep 1920 –21 recession, the low discount
rate may have been fortuitous. As an Assistant Secretary of the Treasury wrote
(Leffingwell 1921, p. 35), “by permitting rates to remain below the open market rates
and credit to be expanded during the period of deflation of prices, it has prevented
the present business depression from degenerating into an old-fashioned panic.” But
over time, of course, freely available discount lending at below-market interest rates
was bound to bring tensions.
Indeed, unbeknownst to the wider world, Fed policy on discount window
lending was fundamentally altered in the mid-1920s. As Shull (1993, p. 20, with
quotations from Keynes, 1930, pp. 239– 40) explains: “A set of non-price rationing
rules, limiting use of the discount window to short-term borrowing for unantici-
pated outflows of funds, were developed; banks were encouraged to be ‘reluctant
to borrow;’ i.e., the Fed “turned to ‘gadgets’ and conventions . . . without any overt
alteration of the law.” Creating a reluctance to borrow can informally come about
through possible implicit threats to examine the borrowing bank more frequently
and intensively, ostensibly to determine whether such borrowing is warranted.
Why was the policy on discount lending changed? There seem to be several
reasons. First, it became clear that hundreds of banks were borrowing from the Fed
for extended periods of time. Shull (1971, p. 35) reports that as of August 31, 1925,
52 Journal of Economic Perspectives

588 banks had been borrowing continuously for at least a year; 239 had been
borrowing since the start of the recession in 1920; and 122 had been borrowing
continuously since before 1920. In addition, “259 national member banks had
failed since 1920, and a guess was made that at least 80 per cent had been habitual
borrowers prior to their failure.” Thus, the Federal Reserve Annual Report of 1926
(p. 4) stated that “the funds of the Federal Reserve banks are ordinarily intended to
be used in meeting temporary requirements of members, and continuous borrowing
by a member bank as a general practice would not be consistent with the intent of
the Federal Reserve Act.”
In addition, by the latter part of the 1920s, the Fed became concerned with
trying to distinguish between “speculative security loans” and loans for “legitimate
business.” In other words, was discount window credit being used to pump up stock
market values (Anderson 1966)? Was it leading to high growth in real estate prices,
labeled a “bubble” by some (White 2009)? The Fed sought to restrain credit growth
through moral suasion that would deter member banks from borrowing for specula-
tive purposes, while at the same time trying to maintain a preferential discount rate
for “legitimate” borrowing (Friedman and Schwartz 1963, p. 225–26). But the Fed
decided that attempting to influence the economy via the discount window was not
going to work. In short, the purpose of the discount window changed. It would no
longer serve to provide an “elastic currency.” While contemporary observers noted
that there had been no banking panics in the 1920s, there appears to have been no
understanding of the details of how freely available lending through the discount
window had avoided the panic. The Fed’s new policy of creating a “reluctance to
borrow” based on nonpecuniary measures, and an emphasis that such lending
should be only temporary, meant that a bank that did borrow from the discount
window must be in trouble. This was the creation of “stigma,” which has compli-
cated lender-of-last-resort policy ever since.

The Great Depression

Explaining the timing and causes of the banking panics of the Great Depres-
sion has been difficult and many researchers have offered explanations.3 There is
a reason that researchers have found this confusing: at the time, bank depositors
were also confused. They had been told repeatedly that banking panics would not
occur under the Federal Reserve System—and in fact, no panics had occurred in
the 1920s. Depositors, however, were unaware of the shift in Fed policy with regard
to the discount window, so depositors reasonably assumed that banks would again
avail themselves of the discount window as needed. But by the late 1920s, banks had
been repeatedly told not to use the discount window, and when the 1930s arrived,

3
This literature is very large and we do not survey it here. As a starting point, see Friedman and Schwartz
(1963), Wicker (1996), and Meltzer (2003). Richardson (2007) relates this literature to new archival data
on bank failures and suspensions (which are not the same thing).
 The Federal Reserve and Panic Prevention 53

they were quite hesitant to do so. As shown in Figure 1, discount window borrowing
from 1929 to 1931 was much lower than in the 1920s, and after peaking in 1932, it
declines slightly. Apparently, banks feared the stigma the Fed policies had created
in the mid-1920s on discount lending.
When the Great Depression started in 1929, there were no bank runs. As
mentioned earlier, Gorton’s (1988) calculations looking at how unexpected
movements in leading indicators had predicted financial crises in the pre-Fed era
suggested that, in the Great Depression, there should have been bank runs starting
in December 1929. Similarly, Wicker (1980, p. 573) noted: “Historically, banking
panics in the United States usually developed shortly after a downturn in economic
activity. The banking crisis in November–December 1930, however, was unlike
previous banking collapses: there was little or no discernible impact on the central
money market, and the panic lagged the downturn by eighteen months.”
Bank runs did not happen in the Great Depression until late in 1930. As
Richardson (2007, p. 40) notes: “Before October 1930, the pattern of [bank] failures
resembled the pattern that prevailed during the 1920s. Small, rural banks with large
loan losses failed at a steady rate. In November 1930, the collapse of correspondent
networks triggered banking panics. Runs rose in number and severity after promi-
nent financial conglomerates in New York and Los Angeles closed amid scandals
covered prominently in the national press.” There is some dispute over which bank
collapse loomed largest. Friedman and Schwartz (1963) argue that the failure of
the Bank of United States on December 11, 1930, was especially important—in part
because of the bank’s name. Wicker (1980, p. 581; 1996) disputes the importance
of that bank failure, and instead cites the collapse of Caldwell and Company in
mid-November as the trigger of the panic. Caldwell was large; it controlled a large
chain of banks in the South.
A second wave of bank runs began in March 1931. There were runs, for
example, on Chicago-area banks that were followed by a 40 percent increase in
postal savings deposits (Wicker 1996, p. 85; for additional discussion, see Calomiris
and Mason 1997). Finally, there was the Panic of 1933, actually in the last quarter
of 1932 and early 1933, which led to President Roosevelt declaring a four-day “bank
holiday” in March 1933, during which banks and the stock exchange were closed
and forbidden to do any business without special government permission.
During this time, although the Federal Reserve was not engaging in much dis-
count lending, the Reconstruction Finance Corporation, established in January 1932
under President Hoover, had started lending to banks in February 1932. The Recon-
struction Finance Corporation action was needed because the Fed took no “positive
action to intervene directly to keep open troubled banks. No direct assistance was
offered other than to discount eligible paper of the [Federal Reserve] member banks”
(Wicker 1996, p. 85). There were 17,000 banks in existence just prior to Roosevelt’s
March 1933 banking holiday. Only 12,000 survived, and half of those were borrowing
some or as much as all of their capital from the Reconstruction Finance Corporation
(Todd 1992). Ironically, the chairman of the Reconstruction Finance Corporation was
Eugene Mayer, who was also chairman of the Fed.
54 Journal of Economic Perspectives

At first, there was apparently no stigma attached to borrowing from the Recon-
struction Finance Corporation until the clerk of the House of Representatives revealed
the names of borrowers in July 1932 (Butkiewicz 1995, 1999; see also Friedman and
Schwartz 1963, p. 331). Figure 2 illustrates the scale of loans from the Reconstruc-
tion Finance Corporation to banks as well as to other institutions like state and local
governments, railroads, and mortgage institutions. Prior to the revelation of borrower
names beginning in July 1932, total Reconstruction Finance Corporation borrowing
had reached approximately $1 billion, with about half of this total going to banks.
Following the name revelation, net bank borrowing flattened out and was below
$500 million four years later, even though nonbank borrowing—where stigma is far
less of an issue—rose to more than $2 billion of the total.
The bank runs of the Great Depression were haphazard, chaotic, and spread
out in time, unlike those of the pre-Fed period. Given that there was no bank run in
1929 at the onset of the Depression, the timing suggests that when depositors even-
tually saw the failures of large banks in the 1930s, they realized that the discount
window mechanism was not working and the bank runs started. What happened?
Friedman and Schwartz (1963, pp. 318–19) write: “The aversion to borrowing by
banks, which the Reserve System had tried to strengthen during the twenties, was
still greater at a time when depositors were fearful for the safety of every bank and
were scrutinizing balance sheets with great care to see which banks were likely to be
the next to go . . .” Wheelock (1990, p. 424) provides some evidence for this:

This study also finds evidence of a downward shift in borrowed reserve demand
during the Depression. Financial crises made banks cautious and less willing
to borrow reserves. The Fed’s failure to recognize this change in bank will-
ingness to borrow contributed to its failure to interpret monetary conditions
accurately. Fed officials continued to believe that low levels of bank borrowing
signaled easy money.

The problem was that the expectations of depositors that banks could and
would avail themselves of the discount window when in trouble were not (widely)
realized. Large banks failed and depositors then ran on the banks.4

New Deal Legislation and the Quiet Period: 1933–1978

The financial legislation of the New Deal period transformed the financial
regulatory system and the role of the Federal Reserve within it; in addition, it

4
We are not making any claims here about the effectiveness of the Fed as a lender of last resort when
banks actually did borrow. For example, Richardson and Troost (2009) contrast the policies of two regional
Federal Reserve Banks (St. Louis and Atlanta) with regard to their responses to bank troubles in
Mississippi during the Great Depression. Atlanta aggressively assisted banks and the bank failure rate was
lower than in the part of Mississippi in the St. Louis district. The interesting question here is how Atlanta
managed to overcome (or avoid) the stigma that depressed borrowing in other districts.
 Gary Gorton and Andrew Metrick 55

Figure 2
Reconstruction Finance Corporation Loans Outstanding

3.5

3.0
Grand total

2.5
Billions of dollars

2.0

1.5

1.0
Banks

.5

0
O

Fe

Se

O
Ap

Ap

Au
Ja

Ju

Ju

Ja
ec
ov
ct

ct
ay

ar
n.

n.
p.
b.
l.

n.
r.

r.

g.
.1

.1
.1
.1

.1
19

19
19

19
19

19
19

19
19

19
93

93
93
93

93
32

33
32

35
33

33
32

35
34

35
1

4
3
2

Source: Federal Reserve, Flow of Funds.

Note: Figure 2 illustrates the scale of loans from the Reconstruction Finance Corporation to banks as well
as to other institutions like state and local governments, railroads, and mortgage institutions.

represented the last major set of changes in financial regulation until the 1970s.5
The Banking Acts of 1933 and 1935 amended the Federal Reserve Act to estab-
lish the Federal Deposit Insurance Corporation. The advent of deposit insurance
rendered moot—for a time—the mistake of developing the policy of “reluctance to
borrow,” and there was no discussion or realization of the problem that had been
created by the discount–rate policies of the 1920s. Over the subsequent 75 years,
the original insurance cap of $2,500 per bank account would be raised many times,
finally reaching $250,000 in the aftermath of the recent financial crisis.
The Banking Acts also had a profound influence on the power and structure
of the Fed. The balance of power between the Board and the regional Reserve
Banks was tipped in favor of the center, with a Board-dominated Federal Open
Market Committee established in 1935. Far more obscure at the time was a small

5
We do not attempt anything close to a review of all financial regulation during this time period. For
a comprehensive treatment of regulatory and competitive changes in the key 1979–1994 period, see
Berger, Kashyap, and Scalise (1995). For a discussion of changes since the 1990s leading to the rising
share of nonbank financial intermediaries, see Gorton and Metrick (2010).
56 Journal of Economic Perspectives

amendment to Section 13 of the Federal Reserve Act, granting the Fed the power
to greatly expand its lending programs under “unusual and exigent circumstances.”
These powers were invoked often in the recent crisis, as discussed later in this paper.6
The Banking Act of 1933 is often known by the last names of its sponsors, Glass
and Steagall, and by the provision of the law that enforced the separation of deposit-
taking and securities underwriting. This separation of banking and securities was
coincident with significant new financial regulation, beginning with the Securities
Act of 1933, which focused on the primary sale of securities, and the Exchange Act
of 1934, which created the Securities and Exchange Commission and focused on the
secondary trading markets. The SEC was granted further powers to regulate market
intermediaries in the Investment Company Act of 1940 (for mutual funds and other
investment companies) and in the Investment Adviser Act of 1940 (which today
covers hedge funds and private equity funds, in addition to traditional advisers).
After the New Deal legislation, the most important piece of financial regulation
to affect the Fed during this time period was the Bank Holding Company Act of
1956, in which the Fed was given oversight responsibility over holding companies
that included commercial banks in their structure, with rules codified about the
separation of banking and nonbanking activities. Importantly, this responsibility
gave the Fed insight and access to the largest commercial banks, all of which (over
time) became part of bank holding companies. The role of bank holding compa-
nies in the overall financial system has increased steadily, so that today they cover
the vast majority of assets in the US banking system.

The Transformation of Banking: 1979–2006

Into the 1970s, banking in the United States was still a relatively simple busi-
ness, at least compared with today, with this simplicity supported by ceilings on the
interest rates that could be paid on time deposits (“Regulation Q”), a prohibition of
paying interest on demand deposits, and by restrictions on both inter- and intrastate
branching of banks. The story of banking since the 1970s is largely about attempts
to work around regulations and the resulting growth in nonbank alternatives in the
far more complex financial system of today. Liquid safe assets—assets that can safely
store value for a short period of time with almost no risk such as money market
mutual funds, and sale and repurchase agreements—began to be produced in large
volumes. In Gorton, Lewellen, and Metrick (2012), we show that the net effect of
these changes is that bank deposits’ share of the “safe” financial assets in the United
States fell from 80 percent in 1952 to less than 30 percent by 2007.

6
The Fed’s emergency-lending power in Section 13(3) was first granted by the Emergency Relief and
Construction Act of 1932, which later received amendments in the Banking Act of 1935 and in Federal
Deposit Insurance Corporation Improvement Act of 1991. As discussed later, these amendments proved
crucial for the lending powers used in the recent crisis (Mehra 2011).
 The Federal Reserve and Panic Prevention 57

One controversial element of bank regulation and supervision has played

a large role in recent Federal Reserve history: the setting of capital standards.
“Capital” in this context is defined in its narrowest sense as the common-equity
component on the right-hand-side of the balance sheet, with various broader defini-
tions including other forms of equity and the present-value of different kinds of safe
revenue claims. For our purposes here, we will just refer to all of these definitions as
“capital,” unless there is an important reason to be more specific.7
The benefit of banks having higher capital should be that each individual bank
has a lower probability of distress. Given the access to the government safety net of
deposit insurance and the lender of last resort, banks may not fully internalize the
social cost of failure. In addition, even in the absence of such access, banks would
not internalize the spillover effects of their own failure on other financial institu-
tions. For these reasons, the government has an interest in lowering the probability
of bank failure by requiring higher levels of capital than may seem privately optimal
to banks.
An international consortium of regulators began work on a set of standards
that could be applied across the major economies; this process culminated in the
“Basel I” accords of 1988, implemented in 1990 in the United States. In the 1990s,
the Basel requirements were revised and updated for riskiness of bank assets,
resulting ultimately in the Basel II accords of 1997. As of 2006, most of the devel-
oped world had fairly complex implementations of capital standards for banks,
with the Fed as the primary regulator for the largest financial holding companies
in the United States. Nevertheless, regulatory capital proved to be a slow-moving
measure of bank health, and in no country did it provide clear warnings of the
coming crisis. In the aftermath of the crisis, the Fed was a main driver of the next
round of “Basel III” accords, although the Basel III standards have not yet been
implemented in the United States. Whether raising bank capital requirements is
desirable has been the subject of great debate.8

7
Our discussion of capital rules and the Basel process focuses on the role played by the Federal Reserve
and the implications for the growth of the shadow banking system. For a more comprehensive treat-
ment, Goodhart (2011) is a definitive history of the Basel process up through 1997, and Hanson,
Kashyap, and Stein (2011) is an accessible survey of the intellectual debate about capital standards in
the post-crisis world.
8
DeAngelo and Stulz (2013) point out that if banks’ liabilities, short-term liquid debt, are useful because
of their liquidity, they have a “convenience yield” (part of the return the holder gets is the benefits of
liquidity) and then banks optimally have high leverage. Kashyap, Stein, and Hanson (2010) point out
that even small increases in the cost of the capital could be sufficient to drive significant flows from banks
into nonbank financial institutions. For the most forceful argument in favor of the Modigliani–Miller
interpretation that raising additional capital would not be costly for banks, see Admati and Hellwig
(2013). Other recent perspectives on this debate include Baker and Wurgler (2013) and Gorton and
Winton (2002).
58 Journal of Economic Perspectives

The Financial Crisis of 2007–2009

When the financial crisis began in 2007, the Federal Reserve faced two major
challenges in its function as lender of last resort. First, the stigma of the discount
window, originally created by the policies of the 1920s, was still causing a reluctance
to borrow by member banks. Second, the sharp growth of a financial sector outside
of member banks—in the so-called “shadow banking” sector where institutions like
money market mutual funds take deposits and funds are invested in bonds and
other financial assets—left a large portion of the financial system without access to
the discount window. Most of the Fed’s actions during the crisis can be viewed as
attempts to deal with these challenges.
Policies both formal (raising the discount rate) and informal (implicit threats to
conduct more extensive and frequent bank examinations) continued to discourage
borrowing from the discount window from the 1920s through the rest of the
twentieth century. Despite an additional change in August 2007 that decreased
the discount-window premium by 50 basis points and increased the eligible term
for discount window loans, banks were still reluctant to borrow throughout 2007.
In an interesting parallel to the role of the Reconstruction Finance Corporation
during the Great Depression, many banks found an alternative source of back-up
liquidity to escape the stigma of the discount window—in this case the Federal
Home Loan Banks. Ashcraft, Beck, and Frame (2010) describe how the FHLB
system became a “lender of next-to-last resort” with over $1 trillion in loans at the
peak of the crisis.
In December 2007, the Fed created the Term Auction Facility in a major attempt
to overcome the reluctance of banks to borrow at the discount window. In the Term
Auction Facility (TAF), the Fed created regular auctions of pre-set total quantities
of loans for set terms (either 28 or 84 days), and the same institutions eligible to use
the discount window were able to submit bids for what they would pay to borrow
these funds. The rules for these loans were similar (although not identical) to those
for the discount window. The institutions that received the loans were not publicly
revealed, and the market apparently believed that some combination of the stigma
and risk of possible disclosure of these loans was significantly lower than those from
the discount window. According to Almantier, Ghysels, Sarkar, and Shrader (2011),
TAF credit outstanding peaked at over $300 billion, nearly three times the peak
for discount window credit. This occurred although interest rates for borrowing
through the Term Auction Facility were higher on average than rates at the discount
window, by an average of 37 basis points overall and more than 150 basis points after
the Lehman bankruptcy in September 2008. Banks were apparently willing to pay a
premium to avoid the stigma of borrowing at the discount window.
Continued pressure in short-term funding markets led to the near-bankruptcy
and fire sale of Bear Stearns to JPMorgan in March 2008. As Bear Stearns was
not a depository institution and thus did not have access to the discount window,
the eventual Fed guarantee that enabled the JPMorgan sale required use of the
13(3) authority granted in the 1930s, its first invocation during the crisis. The
 Gary Gorton and Andrew Metrick 59

Fed also responded by expanding the discount window—historically reserved for

depository institutions—to include a broader group of primary dealers including
Lehman Brothers, Merrill Lynch, and Goldman Sachs. A further expansion of the
lender-of-last-resort function, which also required the use of Section 13(3), authority
came through the Term-Securities Lending Facility (TSLF), which allowed primary
dealers to effectively exchange illiquid securities for government bonds. The Term
Securities Lending Facility was successful in reducing stress in the sale and repur-
chase or “repo” markets (Fleming et al. 2010; Hrung and Seligman 2011), in which
one firm sells securities to another firm and then agrees to repurchase them at a
slightly higher price in the near future—thus in effect receiving a short-term loan
(Gorton and Metrick 2012).
However, the Federal Reserve was only getting started in expanding its role
as lender of last resort for other parts of the shadow banking system. In fall 2008,
13(3) authority was used to create an alphabet soup of facilities, each targeted to extend
the lender-of-last-resort function to another part of the shadow banking system. The
Term Asset-Backed Securities Loan Facility (TALF) allowed borrowers to post various
asset-backed securities as collateral for term loans; the Commercial Paper Funding
Facility (CPFF) created facilities to buy commercial paper directly from issuers; the
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)
purchased asset-backed commercial paper from money-market mutual funds; and the
Money-Market Investor Funding Facility (MMIFF) lent to money-market mutual funds
on a broad range of collateral, effectively acting as a discount window for these funds.
The Fed also used its 13(3) authority to create special-purpose vehicles to support
lending programs to the insurance company AIG in September 2008.
Overall, the Fed made significant use of its 13(3) powers during the crisis,
expanding its role as a lender of last resort well beyond the depository institutions
typically served by the discount window. To go with the lender-of-last-resort func-
tion, the Fed marked the end of the panic phase of the financial crisis with the
Supervisory Capital Assessment Program (SCAP), also known as the “stress tests,”
carried out in spring 2009. The stress tests expanded the standard supervisory
reviews to include considering the stresses that might arise in specific look-ahead
scenarios, an element of what is now called “macroprudential” regulation (that is,
policies aimed at protection of the entire financial system) in which potential reac-
tions across financial firms and markets are considered, not just whether individual
companies seem to be holding sufficient capital.

The Dodd–Frank Act and the Fed’s Role Today

The Dodd–Frank Act of 2010 targeted several of the most glaring holes in the
pre-existing financial regulatory structure, with significant implications for the Federal
Reserve’s role as supervisor and as lender of last resort. As of mid-2013, many important
components of the legislation are still in the rule-writing stage, and thus any assessment
of the law’s effect is necessarily preliminary. The Dodd–Frank Act unambiguously
60 Journal of Economic Perspectives

expanded the Fed’s role as a supervisor of financial institutions. However, the legis-
lation was drafted and passed during a time when the Fed was under tremendous
political and media pressure for its actions during the financial crisis, and this pressure
led to some restrictions on the Fed’s discretionary power as a lender of last resort.
From a supervisory viewpoint, the 2010 legislation created the Financial Stability
Oversight Council, a new coordinating body that has the power to designate some
financial institutions (including nonbanks) as being systemically important, with these
institutions then subject to oversight and (additional) regulation by the Fed. Such
designations effectively make the Fed a primary regulator for all large financial institu-
tions, no matter what their main function. Furthermore, the Fed now has an explicit
mandate to set higher capital standards and to give extra scrutiny to these largest firms.
One motivation of the Dodd–Frank Act was to end public bailouts of the largest
institutions. Such a promise is complex and somewhat at odds with the lender-of-last-
resort function. Specifically, the 13(3) powers that the Federal Reserve used during
the crisis have been restricted by requiring more cooperation with the Treasury,
more disclosure to Congress, and less flexibility to design programs to aid specific
borrowers. In addition to the restrictions on the Fed’s 13(3) powers, other restric-
tions were made on Treasury’s emergency use of rescue powers such as those used
for money-market funds, and the ability of the Federal Deposit Insurance Corpora-
tion to broadly guarantee bank assets without an act of Congress. Taken together,
Dodd–Frank significantly reduced the flexibility of the executive branch and the
Federal Reserve to act quickly during a financial crisis, while expanding their ability
to act pre-emptively before one.
The Dodd–Frank Act did little to address the vulnerabilities in the shadow
banking system at the heart of the panic during the crisis. For instance, repurchase
agreements serve as a market for short-term loans and can be a source of troubles
in a crisis when such loans are not rolled over as expected; yet reform of repurchase
agreements was left entirely out of the legislation, with no clear jurisdiction for
any agency to act. Reform of money market mutual funds was left to the existing
statutory powers of the Securities and Exchange Commission, and it is has proved
difficult (so far) to make significant changes to the status quo. Financial securitiza-
tion received some new rules under which those who originally make loans need to
retain some of the risk, rather than completely passing it on to others, but larger-
scale reforms were not included. The Financial Stability Oversight Council has
some flexibility to address all of these shadow-banking issues in the future, but the
necessary powers are still untested. Overall, the Fed and other regulators still have
significant limitations for liquidity provision and oversight for many of the shadow
banking markets in which financial runs occurred in 2007–2008.

Conclusion

The Federal Reserve plays a central role in financial regulation, with responsi-
bility as both a lender of last resort and as a supervisor for the largest institutions.
 The Federal Reserve and Panic Prevention 61

The discount window was originally intended to provide this lender-of-last-resort

function through the provision of contingent liquidity to banks; that is, there would
always be a credible supplier of liquidity should the state of the world be one in
which depositors would otherwise run on the banks. If this institution was credible,
then depositors would never run. But, in the 1920s the main concern of the Fed
was to discourage discount window borrowing. The intellectual and policy history
of the discount window following the Great Depression is one of discouraging its
use with virtually no thought about its role in preventing crises. In an ideal world,
all depositors (wholesale and retail) would be confident that the Fed would lend
freely in a systemic crisis, while letting all institutions fail outside of a crisis. In the
less-than-ideal real world, there are many challenges to this balance. The Fed is now
in the position of having to try to reestablish its credibility to meet bank runs. We
conclude with a statement of three of these challenges.
First, in the recent financial crisis, the Fed extended its lender-of-last-resort
function beyond traditional banks, recognizing the broad expansion of the finan-
cial system. These programs have been discontinued. To prevent market panics, do
these programs need to be in existence all the time, just like the discount window
for traditional banks?
Second, given the continued reluctance to borrow from the discount window,
and the new informational requirements for other emergency lending programs,
what are the Fed’s best options to reduce the stigma for its lender-of-last-resort func-
tion so that it has the tools to prevent liquidity runs before they start? How can the
expectations of market participants be changed to believe that these programs are
sufficient to prevent runs?
Third, following the passage of the Dodd–Frank Act, the Fed has a greatly
expanded responsibility for supervision of the largest financial institutions and for
the monitoring of financial stability. What is the optimal way to perform these func-
tions to prevent future liquidity crises?

■ Thanks to David Autor, Doug Diamond, Chang-Tai Hseih, Anil Kashyap, Ulrike
Malmendier, Christina Romer, David Romer, and Timothy Taylor for helpful comments, and
to Ellis Tallman for sharing Figure 1, which appears in Tallman (2010).

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