Federal Liquidity Options: Containing Runs on Deposit-Like Assets without Bailouts and Moral Hazard

Sayles for helpful comments and suggestions. In response to the 2008 runs on deposit-like assets, namely repo and money market funds, the Fed created new liquidity facilities for nonbanking institutions and the Treasury guaranteed certain money market fund balances. These extraordinary actions, while justified by officials as necessary to preserve the financial system, did rescue nonbanks by exposing the public to unprecedented risks. Since 2008, despite legislation and regulation, deposit-like assets are still vulnerable to runs. The fallback policy to contain such runs is still ad hoc lending by the Fed. Bailouts, though officially outlawed, may very well be justified and used again. And, finally, because the implicit safety net of government action is still in place, moral hazard remains a feature of the financial landscape. This paper proposes that the Fed auction Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis. Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. In the resulting policy regime, the Fed does not rescue individual firms or industries but fulfills its contractual obligations under options previously sold at market-determined prices. Furthermore, with the cost of contingent liquidity internalized by the purchasers of FLOs, and with other extraordinary provisions of liquidity credibly renounced, moral hazard will drop significantly.-2