During the last financial crisis, what should the Federal Reserve (Fed) have done after credit dried up, creating a liquidity crisis even for borrowers with sterling credit and good collateral? The conventional answer is that during a market-wide liquidity crisis the central bank should act as a lender of last resort to solvent banks by lending to them at a penalty rate against good collateral. Formulated as a rule for central banks by Walter Bagehot in 1873 for the Bank of England, the notion has become the policy norm. When the financial crisis of 2007 occurred, the Fed followed Bagehot’s advice because it had been statutorily charged by Congress to act as the lender of last resort. It was not enough, though, to stem the crisis. Instead, the Fed had to experiment with new ways of injecting stabilizing liquidity into the financial sector. Most of this took place in 2008 through what this article calls “financial hospitals,” since the goal was to rehabilitate financial assets whose trading and collateral value had become impaired. To do this, the Fed relied on its statutory authority for dealing with financial emergencies — section 13(3) of the Federal Reserve Act. Critics from across the political spectrum have accused the Federal Reserve of acting too fast, waiting too long, doing too much, not doing enough, exceeding its statutory authority, and, in any event, doing the wrong thing. The most recent round of criticism involved an unusual consensus in both liberal and conservative camps that the Fed had done a poor job. This article takes on some of these criticisms by analyzing and, in the end, defending the Fed’s financial hospitals. This article argues that the Fed’s evolving mission compelled it to intervene through techniques that, though seemingly novel, were organic to the new credit market. Although the argument set forth here may not persuade every reader, it should, at the least, provide additional information about what the Fed did so that readers can make up their own minds about the Fed’s actions on the basis of a more complete historical and financial record
