In the press conference following the Federal Reserve’s rate-setting meeting on March 22, Fed Chair Jerome Powell spoke about the recent spate of bank collapses: “The question we were all asking ourselves over the first weekend was, ‘How did this happen?’” The risk of a full-blown banking crisis seems overblown, partly because the central bank utilized the Fed balance sheet to limit the risk of contagion and sustain financial stability. As the Fed begins to analyze what went wrong at the failed banks, understanding Fed balance sheet operations can be key for helping investors assess the effectiveness of its crisis response and to keep calm when instability hits the financial system.
As shown in the accompanying chart, the Federal Reserve’s balance sheet grew by roughly $394 billion in just three weeks (March 1-22) as the central bank sought to contain the fallout from the collapse of Silicon Valley Bank. The Fed has a recent history of creating innovative policy tools as part of its “qualitative easing” programs during previous financial crises. These innovations included the Primary Dealer Credit Facility in March 2008 (at the outset of the Global Financial Crisis) and the Municipal Liquidity Facility in April 2020 (in the early days of the COVID-19 pandemic.)
Similarly, the central bank formed the Bank Term Funding Program (BTFP) on March 12, 2023, as a lending facility to prevent a possible banking crisis. The BTFP provides loans to eligible banks of up to one year, backed by collateral that the Fed can purchase in the open market. BTFP is designed to restore confidence in the banking system by allowing banks to avoid selling bond investments at a loss to meet deposit outflows. With BTFP, the Fed effectively acts as an additional source of liquidity for banks when facing funding stress. It may help head off potential runs on bank deposits before contagion spreads.
Another balance sheet tool in the Fed’s arsenal is the “discount window.” The Fed uses the discount window to lend funds on a very short-term basis (typically overnight) to banks when they face a liquidity crunch, such as a wave of depositor withdrawals. In acting as the “lender of last resort” through the discount window, the Fed can seek to stabilize the financial system in times of financial crisis by supporting the smooth flow of credit to businesses and households.
According to the Federal Reserve, banks borrowed approximately $152.9 billion on March 15 through the discount window, surpassing the prior record of $112 billion during the 2008 financial crisis. Moreover, banks borrowed an additional $142 billion on March 15 to meet liquidity needs in what is known as “other credit extensions.” Any increase in these facilities in the coming weeks could signal that depositors are withdrawing funds from more vulnerable financial institutions. That, in turn, may undermine confidence in a healthy banking sector that the Fed is trying to promote.
It remains uncertain what economic impacts may follow the latest banking sector upheaval. For investors, these events can illustrate the value of portfolio diversification and the importance of sticking to a well-crafted financial plan.