District Federal Reserve Banks take some credit risk when they lend to banks at the discount window, or through other lending facilities. They mitigate risk, however, by requiring collateral against all loans they make. In addition, Reserve Banks value collateral and set “haircuts” so that loans are overcollateralized. Despite the credit risk, Reserve Banks have never lost money on a discount-window loan.
A number of central banks have taken on credit risk with their asset purchase programs. The European Central Bank, the Bank of England (BoE), and the Bank of Japan (BoJ), for example, have purchased assets issued by the private sector. In some cases, such as the BoJ, the central bank has retained the credit risk. In other instances, such as with the BoE, the central bank obtained explicit indemnities from its fiscal authority to protect it against any credit risk that could result from these purchases. These indemnities have a similar effect as the Fed’s approach of purchasing only government or government agency-guaranteed securities—the fiscal authority, not the central bank, makes the decision about whether to expose taxpayers to credit risk, and it is the balance sheet of the fiscal authority rather than the central bank that is at risk.
Although the Fed’s MBS purchases are not “credit allocation” in the sense of incurring credit risk, they may affect credit allocation by changing the prices of various securities. Purchasing MBS raises the price of those securities directly. Higher prices for MBS reduce mortgage interest rates, thus supporting the flow of mortgage credit to households. Higher MBS prices also indirectly affect the prices of other securities if private investors reallocate their portfolios toward MBS. So, MBS purchases likely influence private investors’ decisions, at least indirectly. Changing relative prices may influence the private allocation of credit across sectors even without taking credit risk.
It is worth emphasizing that influencing the market prices of credit via central bank large-scale securities purchases is fundamentally different from the central bank itself lending directly to particular borrowers. Even if securities purchases change relative prices in a way that affects private investors’ incentives, the decision to lend to a specific borrower ultimately remains with investors, not the central bank.
We tried to resolve two, sometimes blurred, notions about credit allocation associated with central bank securities purchases: taking credit risk and influencing the price of credit. By purchasing agency MBS, the Fed did not take on credit risk, because the U.S. government or agency guarantee behind these securities makes them essentially risk-free. The Fed may have indirectly affected credit allocation by changing the relative prices of certain credit. Indeed, Fed policymakers have debated the extent to which the Fed’s MBS purchases provide broad-based economic stimulus versus supporting the housing sector specifically—see, for example, the comments of then Chairman Bernanke and President Lacker in this FOMC transcript from 2009. In our next post, we study in more detail how the Fed’s agency MBS purchases affect the U.S. economy.
Antoine Martin and Sam Schulhofer-Wohl, “How Do the Fed's MBS Purchases Affect Credit Allocation?,” Federal Reserve Bank of New York Liberty Street Economics (blog), August 6, 2018, http://libertystreeteconomics.newyorkfed.org/2018/08/how-do-fed-mbs-purchases-affect-credit-allocation.html.