In some countries, like the U.S. and the U.K., stigma appeared to be sufficiently strong that banks did not use the central bank’s liquidity facilities at their disposal as much as would have been socially desirable. 12 During the crisis, the Federal Reserve encouraged banks to borrow at its discount window, to little effect. 13 As can be seen in Figure 5, much activity in the fed funds market took place at rates above the discount rate. 9  Another way to reduce the balance sheet cost faced by the banking sector is to allow nonbanks to hold some of the central bank’s liabilities directly. For example, every dollar invested in the Federal Reserve’s overnight reverse repo facility decreases the amount of reserves held by banks and, thus, the aggregate size of the banking system’s balance sheet by a dollar. 10  Keister (2016) shows that it is optimal to commit to providing liquidity to a bank that faces a run. Moral hazard is addressed ex ante, by setting a Pigouvian tax that gives incentives for the bank to invest in the optimal amount of liquid assets. The tax can be interpreted as liquidity regulation and supervision. Goodfriend and Lacker (1999), however, argue that neither constructive ambiguity nor extended supervisory and regulatory reach can effectively overcome the fundamental forces that cause a central bank to lend. They propose that the only way for a central bank to credibly limit lending is for it to build a reputation over time for restraining lending.
A number of idiosyncratic factors could influence the terms of that trade, such as how desperate the borrower is at the end of the day, which could add unnecessary noise to market rates. Figure 3 illustrates this change. 6 Turning to market discipline, Ulrich notes that the interbank market may perform this function particularly well because it is a peer-to-peer market. I would like to see more empirical research before I can feel comfortable that money markets provide much market discipline, especially in overnight markets. If the monitoring was so good pre-crisis, why did we have a crisis? One reason to question how much money market participants monitor the counterparties to which they lend is that it is hard to appropriate the value from such monitoring. Money market “freezes” may affect financial institutions somewhat indiscriminately, and, for that reason, lenders may prefer to withdraw short-term funding indiscriminately when they fear other lenders might do so. If money market participants provide some market discipline, we could expect nonbank lenders in U.S. money markets to do this effectively. They are sophisticated financial institutions that have established relationships with the banks to which they lend. And, because they lend to these banks on a consistent basis, they have strong incentives to monitor their counterparties. 7 While my assessment is necessarily preliminary, I don’t see a reason why one type of money market activity should be preferred over another.