THE FEDERAL RESERVE’S QUESTIONABLE LEGAL BASIS FOR FOREIGN CENTRAL BANK LIQUIDITY SWAPS

The 2008 financial crash precipitated a liquidity crisis of global proportions. With dollar funding shortages threatening the global financial system, the Federal Reserve turned to foreign central bank liquidity swaps as a key component of its crisis response. First used in the 1960s during the Bretton Woods era, foreign central bank liquidity swaps are essentially contracts between two central banks to lend each other currency. While many analysts praised the Fed’s swap lines for—at least temporarily—easing liquidity strains during the crisis, this Note argues that the Fed acted without statutory authority in establishing a network of swap lines providing aid to foreign economies. Exacerbating this tension, in 2013 the Fed converted its temporary network of swap lines into standing arrangements that select foreign central banks can draw on at any time. This extension of the Fed’s enumerated powers represents a democratically unsanctioned incursion into the realm of foreign affairs. To address this problem, this Note suggests that absent explicit legislative authority for foreign central bank liquidity swaps, the Fed should refashion its network of swap lines as an exercise of its emergency powers under Section 13(3) of the Federal Reserve Act, as amended by Dodd–Frank. While such a change is not without significant cost, doing so would imbue transparency, accountability, and legal legitimacy into the Fed’s swap network.

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* J.D. Candidate 2020, Columbia Law School. Many thanks to Professor Kathryn Judge for her guidance and support in writing this Note. Thank you to Benjamin Marrow for helping to kickstart this research, as well as to the staff of the Columbia Law Review for their fantastic editorial assistance. Lastly, special thanks to my grandma and the rest of my family for their endless support and encouragement.

Introduction

In response to the 2008 financial crisis, the Federal Reserve implemented a bevy of lending programs that dramatically altered the composition of the central bank’s balance sheet and helped restore dollar liquidity in certain distressed markets both at home and abroad. 1 While the subprime crisis and toxic array of mortgage-based financial products (such as collateralized debt obligations and credit default swaps) originated in the United States, the modern proliferation of cross-border flows of capital ensured that a crisis would reverberate far beyond its borders. See John Cassidy, The Real Cost of the 2008 Financial Crisis, New Yorker (Sept. 10, 2018), https://www.newyorker.com/magazine/2018/09/17/the-real-cost-of-the-2008-financial-crisis (on file with the Columbia Law Review) (“Although the major international banks were domiciled and regulated in their individual countries, they were operating in a single, integrated capital market. So, when the crisis struck and many sources of short-term bank funding dried up, the European banks were left tottering.”). A major reason the world avoided an unmitigated international banking disaster was the Fed’s injection of trillions of dollars of liquidity into the global banking system. 2 See, e.g., Adam Tooze, The Forgotten History of the Financial Crisis, Foreign Aff., Sept./Oct. 2018, https://www.foreignaffairs.com/articles/world/2018-08-13/forgotten-history-financial-crisis (on file with the Columbia Law Review) [hereinafter Tooze, The Forgotten History] (“[B]etween December 2007 and August 2010, the Fed provided its Asian, European, and Latin American counterparts with just shy of $4.5 trillion in liquidity, of which the ECB alone took $2.5 trillion.”). One of the Fed’s most innovative facilities during the crisis was its revival of foreign central bank liquidity swaps (or swap lines). In broad strokes, the Fed used swap lines during the financial crisis to lend substantial amounts of U.S. dollars to foreign central banks, which in turn distributed the borrowed currency to dollar-needy financial institutions in their respective jurisdictions. 3 At the program’s peak in December 2008, outstanding swaps totaled more than $580 billion. Jon Hilsenrath, A Primer on the Fed’s Swap Lines with Europe, Wall St. J.: Real Time Econ. (May 10, 2010), https://blogs.wsj.com/economics/2010/05/10/a-primer-on-the-feds-swap-lines-with-europe/ (on file with the Columbia Law Review). For more on the mechanics of foreign central bank liquidity swaps, see infra section I.A. These swap lines have largely flown under the radar in public discourse, despite some expert opinions that “the swap lines with which the Fed pumped dollars into the world economy were perhaps the decisive innovation of the crisis.” 4 Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World 11, 210–15 (2018) [hereinafter Tooze, Crashed] (“The absence of a euro-dollar or a sterling-dollar currency crisis was one of the remarkable features of 2008 . . . . It was the swap lines that did the trick.”); see also William A. Allen & Richhild Moessner, The International Liquidity Crisis of 2008–2009, World Econ., Apr.–June 2011, at 183, 184 (“[T]he financial stability problems faced by several of the recipient countries would have been much more severe had the swap facilities not been made available.”).

The Fed first used foreign central bank liquidity swaps in the early 1960s as a tool to protect the value of the dollar in foreign exchange markets during the Bretton Woods era. 5 See Michael D. Bordo, Owen F. Humpage & Anna J. Schwartz, The Evolution of the Federal Reserve Swap Lines Since 1962, at 1 (Nat’l Bureau of Econ. Research, Working Paper No. 20755, 2014), https://www.nber.org/papers/w20755.pdf [https://perma.cc/D637-H98G] [hereinafter Bordo et al., Evolution of the Federal Reserve Swap Lines] (“What started out as a device to provide central banks with cover for unwanted dollar positions had returned as a way to finance global lender-of-last-resort operations . . . .”). The Bretton Woods Agreement of 1944 established an international monetary system that pegged the dollar to gold and fixed the currencies of cooperating nations within a one-percent band of the dollar. The Bretton Woods system lasted until 1971. See infra notes 35–62 and accompanying text. More recently, the Fed repurposed the swap lines during the financial crisis to help address disruptions in dollar funding of banks in foreign jurisdictions. 6 See Bordo et al., Evolution of the Federal Reserve Swap Lines, supra note 5, at 1; see also Tooze, Crashed, supra note 4, at 214 (“What the Fed had done for money markets, the central banks now did for the global provision of dollar bank funding.”). The swap lines have continued to serve this purpose ever since. In May 2010, amid the Eurozone crisis, the Fed reestablished temporary liquidity swap facilities with four major central banks to “help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers.” 7 Press Release, Bd. of Governors of the Fed. Reserve Sys., FOMC Statement: Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank Announce Reestablishment of Temporary U.S. Dollar Liquidity Swap Facilities (May 9, 2010), https://www.federalreserve.gov/newsevents/pressreleases/monetary20100509a.htm [https://perma.cc/8Y4M-LMJT] [hereinafter FOMC Press Release, May 9, 2010]. Shortly after, in 2013, the Fed transformed this web of currency swaps into standing arrangements as part of “a prudent liquidity backstop” to “ease strains in financial markets and mitigate their effects on economic conditions.” 8 Press Release, Bd. of Governors of the Fed. Reserve Sys., Federal Reserve and Other Central Banks Convert Temporary Bilateral Liquidity Swap Arrangements to Standing Arrangements (Oct. 31, 2013), https://www.federalreserve.gov/newsevents/pressreleases/monetary20131031a.htm [https://perma.cc/G3AF-G2YZ] [hereinafter Fed. Press Release, Oct. 31, 2013] (adding the Bank of Japan to this network of bilateral liquidity swap arrangements). These swap lines have constituted a significant portion of the Fed’s balance sheet, 9 See Credit and Liquidity Programs and the Balance Sheets: Balance Sheet Trends—Accessible, Bd. of Governors of the Fed. Reserve Sys., https://www.federalreserve.gov/monetarypolicy/bst_recenttrends_accessible.htm [https://perma.cc/FST9-YM4C] (last visited Nov. 5, 2019) (recording the highest amount of central bank liquidity swaps outstanding on December 17, 2008, when they comprised approximately 26% of the Federal Reserve’s assets). According to the New York Federal Reserve Bank’s tally of central bank liquidity swap operations, as of October 30, 2019, there were forty-one million dollars’ worth of outstanding liquidity swaps, thirty-six million of which were issued to the European Central Bank (ECB) and five million of which to the Bank of England. Central Bank Liquidity Swap Operations, Fed. Reserve Bank of N.Y., https://apps.newyorkfed.org/markets/autorates/fxswap [https://perma.cc/6DGY-ZMMC] (last visited Nov. 5, 2019). and the Fed operates with stark autonomy in authorizing foreign central bank liquidity swaps. 10 See Colleen Baker, The Federal Reserve’s Use of International Swap Lines, 55 Ariz. L. Rev. 603, 607–09 (2013) [hereinafter Baker, Swap Lines] (noting that the Fed neither needs to seek Congressional approval nor relies upon emergency legal authority to activate the swap lines).

Despite the modern expansion of swap lines and the corresponding shift in their use, the Fed has continued to rely upon an attenuated interpretation of Section 14 of the Federal Reserve Act 11 Section 14 is a catchall provision that governs open market operations, which are generally under the purview of the Federal Open Markets Committee (FOMC). Notably, the provisions of Section 14 contain no language dealing directly with foreign central bank liquidity swaps. See Federal Reserve Act, Pub. L. No. 63-43, § 14, 38 Stat. 251, 264–65 (1913) (codified as amended at 12 U.S.C. §§ 353–355 (2018)). that was developed in the 1960s as authority to create and enter into liquidity swaps. 12 See Central Bank Liquidity Swaps, Bd. of Governors of the Fed. Reserve Sys., https://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm [https://perma.cc/MB8T-R6QV] [hereinafter Fed Explainer on Central Bank Liquidity Swaps] (last updated Oct. 17, 2018) (“The Federal Reserve operates these swap lines under the authority of [S]ection 14 of the Federal Reserve Act . . . .”). For more on the circumstances and debate during the 1960s over the Fed’s legal power to intervene in foreign exchange markets, see infra section II.A. In light of the extensive and controversial 13 For one, the Fed has no means to track who ultimately receives the dollars distributed by foreign central banks that draw on swap lines with the Fed. See Monetary Policy and the State of the Economy: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 55–56 (2009) (recording a dramatic exchange between Fed Chairman Ben Bernanke and Congressman Alan Grayson, in which Bernanke admitted he did not know who specifically received $533 billion from central bank liquidity swaps during the financial crisis). Furthermore, experts have accused the Fed of cultivating moral hazard by selectively lending to large foreign institutions and by bailing out failing foreign monetary systems. See, e.g., Gerald P. O’Driscoll Jr., The Federal Reserve’s Covert Bailout of Europe, Wall St. J. (Dec. 28, 2011), https://www.wsj.com/articles/SB10001424052970204464404577118682763082876 (on file with the Columbia Law Review) (“No matter the legalistic interpretation, the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments.”). power wielded by the Fed in entering into foreign central bank liquidity swaps, the academic discussion of the Federal Reserve’s legal basis for using these arrangements has been surprisingly sparse. 14 While a number of scholars and commentators, such as Colleen Baker and Peter Conti-Brown, have acknowledged that the Fed’s swap lines rest on shaky legal grounds, the analysis of the relevant law as it relates to the current incarnation of central bank liquidity swaps largely seems to have stopped there. See, e.g., Baker, Swap Lines, supra note 10, at 610 (pointing out that “[t]he legal authority for the Federal Reserve’s swap lines is antiquated and woefully inadequate” and that to the author’s knowledge “this is the first law review article to offer a theoretical analysis” of the Fed’s swap lines); Peter Conti-Brown, The Institutions of Federal Reserve Independence, 32 Yale J. on Reg. 257, 258–63 (2015) (“The Article explains the context and historical change of the many mechanisms of Fed independence, providing for the first time an explanation of how the Fed’s funding, appointments, and removability protections have evolved since they were first installed by the Federal Reserve Act of 1913 . . . .”). The Fed contends that Congress has provided tacit approval for the Fed’s swap lines since their initial use in the early 1960s. 15 See, e.g., Robert L. Hetzel, Sterilized Foreign Exchange Intervention: The Fed Debate in the 1960s, Fed. Res. Bank Richmond Econ. Q., Spring 1996, at 21, 39 n.9 [hereinafter Hetzel, Fed Debate in the 1960s] (noting that Congress has been fully aware of the Fed’s swap line activity since 1962, yet Congress has not acted to restrict the authority of the Federal Reserve to engage in these operations). To the contrary, this Note argues that the Fed’s legal theory supporting its foreign central bank liquidity swaps is inadequate to justify the swap network in its current form. To legitimize the Fed’s use of foreign central bank liquidity swaps, Congress should provide clear legislative authority for the Fed to issue and maintain swap lines. In the absence of such explicit direction, this Note contends that the current statutory framework contains a firmer legal basis that can justify the Fed’s liquidity swaps. As the ensuing analysis seeks to demonstrate, the Fed would be on stronger footing if it reconstructed its liquidity swap framework as an emergency power under Section 13(3) of the Federal Reserve Act, as amended by the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). 16 See Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank), Pub. L. No. 111-203, § 1101, 124 Stat. 1376, 2113–15 (2010) (codified at 12 U.S.C. § 343).

This Note proceeds in three parts. Part I explains the mechanics of foreign central bank liquidity swaps, the circumstances that prompted the Fed to first use liquidity swaps in the 1960s, and the subsequent evolution of the swap lines during and after the financial crisis. Part II outlines the Fed’s current legal basis for the swap lines and analyzes a number of instances when Congress has amended relevant provisions of the Federal Reserve Act, pushing back against the argument that Congress has tacitly approved the swap lines in their current form. Finally, Part III analyzes Section 13(3) and the Fed’s emergency powers as an alternative and superior legal basis for the Fed’s central bank liquidity swaps.