How the Fed Became a Lender of Immediate Resort

The greatest threat to the independence of the US Federal Reserve does not come from President Donald Trump’s attacks or a Supreme Court ruling that might expand his authority. It is the Fed’s longer-term shift from lender of last resort to lender of immediate resort. Without a clear distinction between temporary liquidity support and protection for insolvent institutions, the Fed’s independence turns into cover for ad hoc bailouts, and monetary policy becomes a hostage of weak institutions and authorities’ reluctance to admit supervisory failure.

With each successive crisis over the past decade and a half, from 2007-08 to the 2020 COVID-19 shock and the mid-size bank turmoil of 2023, the Fed has steadily expanded the scope and scale of its interventions. What began as emergency liquidity support has become a recurring feature of financial-market management.

When every disruption is said to generate “spillovers” and every balance-sheet wobble prompts intervention, the distinction between containing panics and propping up failing institutions collapses, and with it goes the discipline that keeps moral hazard in check. At that point, independence can no longer enforce restraint; it merely shields open-ended emergency measures.

The benchmark for central-bank restraint was set by Walter Bagehot more than a century ago: lend early and freely, but only to solvent institutions, against good collateral, and at a penalty rate. Under this elegant framework, the central bank supplies liquidity, the fiscal authority provides capital, and markets impose accountability. Viable institutions are insulated from liquidity panics, while insolvent ones are restructured or shut down.

That framework endured so long as the boundaries between regulated banks and the rest of the financial system were clearly defined, and the line between liquidity and solvency was easier to draw. Modern crises have made it harder to sustain the latter distinction, as sharp asset-price declines can quickly undermine institutions that appear stable.

With non-bank entities increasingly performing bank-like functions without comparable oversight, the Fed extended its reach in 2008 and again in 2020, broadening collateral standards and creating new lending facilities on the fly. By the time the pandemic hit, interventions once considered extraordinary had become routine. While each step may have been defensible in isolation, together they pushed the Fed beyond the limits that preserved its legitimacy.

Whereas illiquidity is a short-term funding problem, insolvency reflects long-term balance-sheet weaknesses that can be addressed only through new equity, mergers, or orderly resolution. The key challenge facing policymakers is to determine whether an institution is solvent yet temporarily illiquid, or insolvent and therefore in need of restructuring. If regulators cannot draw this distinction for banks, despite having granular supervisory data, they certainly cannot do so for non-banks, where visibility is limited.

The turmoil of 2023 underscored the risks created by the Fed’s mission creep. My co-authors and I estimated that hundreds of banks faced large mark-to-market losses on long-duration assets, operated with thin capital buffers, and relied heavily on uninsured deposits. Yet instead of calling for restructuring or new equity, the episode was widely framed as a liquidity crisis. New facilities effectively extended support to roughly $9 trillion in uninsured deposits, vastly expanding the safety net.

By acting as a lender of immediate resort, the Fed may have steadied markets, but it also left the underlying incentives unchanged, setting the stage for the next crisis and putting its independence under strain. Higher interest rates, though necessary to rein in inflation, exposed widespread interest-rate risk across the banking system. This left the Fed in a bind: raise rates dramatically and risk breaking the weakest banks, or hold back and allow inflation to run wild. Financial fragility, in effect, became an undeclared ceiling on monetary tightening.

The Fed’s dual role as bank supervisor and monetary authority magnifies the conflict. The problem is that admitting supervisory failures or concealed solvency problems is politically costly. That creates a strong incentive for the Fed to characterize balance-sheet weaknesses as liquidity issues, leading to a pro-intervention bias that runs counter to the very purpose of central-bank independence.

The answer is not to abandon Bagehot’s framework but to update it. To this end, the Fed should set clear conditions for when emergency facilities can be activated, publish transparent eligibility rules that restrict lending to solvent institutions, impose robust penalty rates and haircuts, and publicly disclose how each facility was used once it is wound down.

Most importantly, the Fed should limit itself to liquidity support and leave solvency issues to markets and fiscal authorities. Without that separation, the Fed will continue to drift toward industrial policy, undermining its legitimacy and independence.

While some may argue that these safeguards already exist, recent interventions have lacked the one constraint capable of limiting moral hazard: automatic mechanisms that force markets to determine whether an institution deserves to survive. Banks that receive liquidity support should be required to raise equity commensurate with that support within a defined window or face restructuring or consolidation. If markets are unwilling to provide capital, the institution is not illiquid – it is insolvent.

Central-bank independence must rest on sound governance, transparency, and accountability. That includes acknowledging supervisory failures when a solvency problem is misjudged as a liquidity one, and explaining how those failures will be addressed rather than masking them through intervention. After all, a central bank that cannot refuse intervention during a crisis cannot be expected to hold its ground when tightening monetary policy.

To protect its credibility, the Fed must resist the temptation to treat every problem as systemic. Otherwise, the financial system will remain fragile by design, and the Fed’s credibility will erode every time it rescues another institution that should have been allowed to fail.

© Project Syndicate 1995–2025