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I’ve been recommending the following for the Fed for quite a while (see Proposals for the Fed):

1. Lower the discount rate the Fed Funds rate and:
   1. Accept a pledge of any bank legal collateral from any member bank.
   2. Impose no restriction on quantity borrowed.
   3. Impose no restriction on the duration of any member bank borrowing.

2. Likewise, remove collateral restrictions on the TAF operations.
   1. Set the maturity and interest rate for each TAF operation.
   2. Leave demand open-ended, rather than the current policy of limiting quantity.

Failure to implement the above shows a failure to understand fundamental monetary operations.

These policy changes would alleviate critical liquidity issues, and not, per se, alter net bank reserve demand (not that the size of the bank reserve ‘matters’).

Part of the current crisis is due to the failure to implement the above changes that would have:

1. Normalized bank liquidity.
2. Prevented the forced sales of investment grade, unimpaired, bank legal assets.
3. Allowed banks to finance bank legal assets for third parties.
4. Allowed markets to function to deleverage impaired assets.

The Fed is slowly moving in that direction, but, unfortunately, not proactively to ‘fix’ a flawed institutional structure, but reactively as things fall apart in no small part due to lack of action:

Federal Reserve lowers standards for collateral from primary dealers

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

Also, Schedule 2 TSLF auctions will be conducted each week; previously, Schedule 2 auctions had been conducted every two weeks. In addition, the amounts offered under Schedule 2 auctions will be increased to a total of $150 billion, from a total of $125 billion. Amounts offered in Schedule 1 auctions will remain at a total of $50 billion. Thus, the total amount offered in the TSLF program will rise to $200 billion from $175 billion.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.

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