Statement for the Record, Hearing on ‘Lending in a Crisis: Reviewing the Federal Reserve’s Emergency Lending Powers During the Pandemic and Examining Proposals to Address Future Economic Crises’

My name is George Selgin, and I am a Senior Fellow at the Cato Institute, and Director Emeritus of its Center for Monetary and Financial Alternatives. On my own and the Center’s behalf, I thank you for this opportunity to share my thoughts concerning the Federal Reserve’s emergency lending during the pandemic. Although tomorrow’s hearing, on “Lending in a Crisis: Reviewing the Federal Reserve’s Emergency Lending Powers During the Pandemic and Examining Proposals to Address Future Economic Crises,” concerns all facets of that lending, and I believe that all of the Federal Reserve’s emergency lending programs warrant your scrutiny, my statement only concerns the Fed’s Main Street Lending Program.

Launched in mid-June 2020, the Federal Reserve’s Main Street Lending Program (MSLP) was originally designed to enhance the supply of credit to businesses with less than $2.5 billion in revenue and employing no more than 10,000 workers. Participating commercial banks would originate the program’s loans, and would retain a 5 percent share in them, with the balance purchased by the Federal Reserve banks. Of $454 billion in funding granted by the CARES Act to the U.S. Treasury for the purpose of supporting the Fed’s emergency lending programs, $75 billion were assigned to the MSLP.

Although the MSLP had a maximum lending capacity of $600 billion, or 12.5 times its Treasury-supplied capital, the program initially proved far less popular with both banks and borrowers than its designers had hoped. In an effort to increase its popularity, Fed and Treasury officials relaxed those terms. Among other changes, firms with up to $5 billion in revenue, or as many as 15,000 employees, were made eligible; loans’ terms were increased from four to five years; the minimum loan size was reduced from $500,000 to $250,000 and ultimately to just $100,000; and the maximum loan amount was raised to $35 million for new loans and $300 million for expanded loans.

Even so, Main Street loan uptake remained disappointing: when lending under the program ceased in early January 2021, it had made 1,830 loans amounting to $17.5 billion—just 2.9 percent of its capacity. Of the nation’s 4,500-odd commercial banks, only some 300 took part in the program. Most were smaller banks, one of which—the City National Bank of Miami—alone accounted for $4 billion, or 22.8 percent, of all Main Street loans! And instead of serving to finance firms’ ongoing operations, 74 percent of the program’s loans were used to pay-off their debts to other lenders.

To put these numbers in perspective, by its termination in May 2021, the Small Business Administration’s (SBA’s) Paycheck Protection Program had lent over $780 billion, or more than twice its original $349 billion CARE Act allocation, while between March and July 2020 alone, total commercial bank C&I (Commercial and Industrial) lending increased by about $700 billion, or roughly 30 percent.

Although the statistics make it difficult to portray the Main Street Lending Program as a success, this hasn’t kept its administrators from trying. Thus, a March 2021 Boston Fed study, after observing that “the volume of loans made under the Main Street program was about 60 percent of the volume of comparable loans made outside the program,” concludes “that the program was a notable addition to the supply of credit to targeted borrowers.” But the 60 percent figure only refers to commercial bank loans originated between August and December 2020, ignoring firms’ extraordinary use of lines of credit¹ established before then, which many were allowed to draw upon on unusually favorable terms.² Taking those lines of credit into account, the Fed’s contribution to “Main Street” lending was trivial.

How could a program that Fed and Treasury officials spent many weeks designing have fallen so far short of expectations? The simple answer is that those expectations were never realistic, as Fed and Treasury officials might have known had they consulted the historical record.

Although the Fed’s 13(3) emergency lending authority, allowing it to lend to non-bank businesses, was granted it as part of the 1932 Emergency Relief and Construction Act, the Fed interpreted the collateral requirements for 13(3) loans so strictly that throughout the Great Depression it only made 123 business loans, totaling just $1.5 million, using that provision. To encourage further Fed lending to non-bank businesses, in 1934 a section 13(b) was added to the Federal Reserve Act, allowing the Fed to extend credit to businesses on terms not unlike those of its recent Main Street Facilities.

But that program also proved disappointing: despite $280 million in Treasury backing, by the end of 1935 the Fed had granted just $124.5 million in 13(b) credit to 1,993 businesses—a tiny fraction of total commercial bank loans, which exceeded $16 billion at their 1933 nadir.³ In most subsequent years, the volume of 13(b) lending amounted to a mere trickle. It was partly for this reason (and as a replacement for the Reconstruction Finance Corporation) that the Small Business Administration, which administered the CARES Act’s Paycheck Protection Program, was established in 1953.

Why has the Fed proven so much less capable than the SBA of channeling credit to businesses? The simple answer is that, while it can make loans without the expectation of having them repaid—provided borrowers meet certain conditions, their Paycheck Protection Program (PPP) loans will be forgiven—the Fed cannot. Instead, it is generally supposed to confine itself to loans and investments that leave its capital intact, assuming they don’t augment it. Dodd-Frank rules, in particular, require that the Fed’s 13(3) lending arrangements “ensure … that the security for emergency loans is sufficient to protect taxpayers from losses.”

With regard to the MSLP, the Dodd-Frank rule was understood to mean that it could afford to lose no more than $75 billion—its Treasury backstop. In practice, owing in part to Fed officials’ inability to anticipate MSLP loan losses with any degree of accuracy, but mainly to pressure from the Treasury, which seemed to look upon its Fed backstop as a loan rather than a grant, the terms of the MSLP ended up being made strict enough to keep its expected loan losses far below $75 billion.⁴ As of their September 10th emergency lending facilities report, Fed officials had recognized $4 billion in MSLP loan losses—a figure implying a hefty loss rate of just under 23 percent, but only a small fraction of the MSLP’s Treasury backstop.⁵

No one knows just how many firms too large to qualify for PPP loans, and too small to issue their own commercial paper, might have been worthy targets of a more generous Main Street Lending Program. But there is little doubt that, by deciding to channel such support through the Federal Reserve System, the government in effect chose to make it available only on terms far stricter than those available to smaller firms only through the Small Business Administration’s PPP program. It was rather as if a lifeguard decided that, while mouth-to-mouth resuscitation would be administered to all drowning victims, some would only receive it through a cocktail straw.

Had there been clear advantages to relying on the Fed, those advantages might have made up for the constraints that went hand-in-hand with its involvement. But the advantage of Fed involvement most often cited by Fed and Treasury officials—that by relying on it, the government could “lever up” its $454 billion in CARES Act funding to as much as $4 trillion in total emergency business support, was entirely fictitious.⁶ It was so, not just because much of the supposed levering up never happened, but also because, if it had happened, it would not have made the programs any cheaper than if they’d been fully funded by Congress. The only differences would have been that, instead of the government borrowing more, the Fed would have done so; and interest, instead of being paid by the Treasury to holders of government securities, would have been paid by the Fed to banks holding reserve balances backed by the Fed’s Main Street loans. Because the Fed’s interest payments reduce its Treasury remittances, and the interest rate on reserves has generally been at least as high as the rate paid on most government securities, the ultimate burden born by taxpayers would have been roughly the same as that created by $525 billion ($600 billion — $75 billion) in additional CARES Act funding.

What lesson should the Fed’s Main Street lending experience teach us? What steps can Congress take to make sure that future emergency lending arrangements avoid the MSLP’s shortcomings? The main lesson seems obvious: emergency business lending is not the Fed’s forte. Nor is risky lending of any sort. But emergency business lending is essentially risky lending: unlike banks, which have only the Fed to turn to when they run short of liquidity, non-bank businesses can generally rely on commercial banks for credit. If they turn to the Fed for emergency loans, it is either because those loans are offered on especially lenient terms, or because they are denied credit elsewhere. It follows that a Fed determined not to become a business lender of first resort must either take on very risky loans or do very little business lending. As we’ve seen, in practice it tends to err on the conservative side.

What steps might Congress take to avoid this outcome? The answer here is also fairly obvious: keep the Fed out of the business of emergency lending to businesses, or at least avoid relying upon it as a source of funding for such lending: far from offering Congress a “free emergency lunch,” in practice having the Fed fund emergency business lending means offering struggling businesses very little emergency support.

Instead of relying on the Fed as a source of emergency credit for Main Street, Congress should plan to fully fund any future emergency Main Street lending program.⁷ It might still involve the Fed in such efforts, but as a program administrator only rather than a source of funds. Alternatively, some other existing agency, or an agency established for the purpose, could be made responsible for administering emergency business loans. So long as the Fed isn’t relied upon for funding, there would be no need for strict lending terms aimed at ruling-out any risk of losses resulting in an unauthorized use of unappropriated public funds. Instead, the terms could be chosen with no aim save that of achieving the lending program’s goal of avoiding wasteful business failures and consequent unemployment. Loans might then be forgiven, or even replaced by outright grants, whenever such concessions appeared worthwhile.

To avoid having Congress once again pass the buck to the Fed, Section 13(3) of the Federal Reserve Act should in turn be clarified to rule-out Fed lending to ordinary non-bank businesses. This can be done by replacing the vague requirement that the Fed “ensure … that the security for emergency loans is sufficient to protect taxpayers from losses” with language stipulating that all of the Fed’s 13(3) loans must either be fully secured by readily marketable collateral or financed using Treasury-supplied capital only.

I understand the temptation to address the challenge of emergency business lending by pursuing a course opposite the one I’ve suggested, that is, by amending section 13(3) of the Federal Reserve Act so as to further loosen the limits on such lending. I urge the committee to resist that temptation, and I hope it will convince Congress to do so. For what may seem like an “obvious” way to encourage more Fed emergency business lending is instead likely to result in yet another failed Main Street lending effort. The roots of Fed’s unwillingness to make risky business loans, except on terms that must discourage most would-be borrowers, or bank participants, or both, do not reside in section 13(3) of the Federal Reserve Act. Instead, they can be traced to the Fed’s basic constitution, with its privilege of being self-funding, though only within strictly-defined limits; and from there to Article 1 of the U.S. Constitution, which otherwise grants Congress alone the “power of the purse,” meaning the power to dispose of public monies.⁸ Only by tampering with both of these constitutions might the Fed be turned into an effective source of emergency funding for struggling businesses. So long as other options are available, I hope that you will agree that such tampering can hardly be considered prudent; and I thank you again for considering my remarks.