Originally published May 2023.

Since March, we have experienced three of the largest bank failures in United States history. Silicon Valley Bank, Signature Bank, and New Republic Bank had combined assets worth over half a trillion dollars — roughly equivalent to the combined assets of the 165 banks that failed in 2008 and 2009. The Federal Reserve has responded to these failures by injecting emergency liquidity into the banking system, reversing months of quantitative tightening.

Commentators have argued that these failures have put the Fed in a challenging position. The Fed must flood the banking system with reserves to prevent a financial crisis. But doing so may undermine the Fed’s ability to bring down historically high inflation. While monetary policymakers are in an unenviable position, these concerns are overblown for two reasons. First, monetary stimulus does not generally have the same effect on the economy as emergency lending. Second, and more importantly, the Fed’s operating framework reduces the extent to which changes in reserves affect the broader money supply.

Suppose several banks become illiquid simultaneously, perhaps because of an unexpected outflow of deposits, and cannot borrow reserves from other banks as a result. The Fed can step in as the lender of last resort to provide emergency loans to these banks through the discount window, provided that the banks in need have good collateral. By providing emergency liquidity, the Fed can prevent these banks from having to liquidate their assets at fire-sale prices, which — if left unchecked — could trigger a financial crisis.