“In the crisis, the Fed played a huge role in determining which firms lived and which died. Its loans helped save the American International Group, but it declined to provide similar aid…
…to Lehman Brothers, whose collapse transmitted stress through the financial system into the wider economy. Dodd-Frank prevented the Fed from setting up a loan facility for just one firm. In theory, this now makes an A.I.G.-type rescue illegal — although Congress could always vote in a crisis to lift that ban.”, Peter Eavis, “New Fed Rule Limits Emergency Lending Power”, The New York Times, December 1, 2015
New Fed Rule Limits Emergency Lending Power
By PETER EAVIS
Janet Yellen is the Fed chairwoman. The five members of the Fed’s board on Monday voted to approve the new rule, which takes effect Jan. 1. Credit Michael Reynolds/European Pressphoto Agency
In the lead-up to the financial crisis of 2008, the Federal Reserve had the ability to make huge emergency loans to almost any entity it chose, a power it used to help save Wall Street firms from possible collapse.
Now, seven years later, the Fed, under the direction of Congress, has adopted a new rule that would place restrictions on its extraordinary financial powers. The restrictions, which stem from the Dodd-Frank Act of 2010, aim to ensure that the Fed’s emergency loans are not used to shore up insolvent firms.
The five members of the Fed’s board on Monday voted to approve the rule, which takes effect on Jan. 1.
The Fed’s emergency loans point to a quandary at the heart of the financial system. Many specialists say central banks, so-called lenders of last resort, need to have a free hand to lend liberally in a crisis to keep panics from taking down healthy firms. But others say the availability of emergency loans encourages banks to pursue habits — like making excessive use of short-term borrowing to finance their activities — that make the system unstable in the first place.
Dodd-Frank’s architects tried to maintain much of the Fed’s latitude while preventing banks from taking advantage of the Fed’s largess.
In recent months, Democrats and Republicans in Congress have called on the Fed to take specific steps to make sure that its final rule on emergency lending fulfills Dodd-Frank’s intent.
Janet L. Yellen, the chairwoman of the Fed, said on Monday that the Fed had taken such recommendations into account. “In response to these comments, we have made significant changes to the proposed rule to ensure that our rule will be applied in a manner that aligns with the intent of the Congress and the Dodd-Frank Act,” she said in a statement.
In the crisis, the Fed played a huge role in determining which firms lived and which died. Its loans helped save the American International Group, but it declined to provide similar aid to Lehman Brothers, whose collapse transmitted stress through the financial system into the wider economy.
Dodd-Frank prevented the Fed from setting up a loan facility for just one firm. In theory, this now makes an A.I.G.-type rescue illegal — although Congress could always vote in a crisis to lift that ban.
Dodd-Frank does allow the Fed to set up emergency loan facilities that many firms can tap in a crisis. And the legislation required that the Fed devise measures that would prevent the loans from going to insolvent firms.
Members of Congress suggested some of the measures that the Fed included in its final rule. To make sure the loans are broadly available, the rule says that at least five firms have to be eligible to borrow from an emergency loan program, preventing the loans from being tailored to suit just one. That number of eligible firms was contained in a bill introduced into the Senate in May by Elizabeth Warren, Democrat of Massachusetts, and David Vitter, Republican of Louisiana.
The Fed’s rule also contains specific measures to make sure insolvent firms are disqualified from the emergency loans. The Fed’s rule says an entity cannot borrow for the purpose of lending to another entity that is insolvent. Representative Jeb Hensarling, Republican of Texas and chairman of the House Financial Services Committee, called for such a measure in a letter that he sent to the Fed last year.
Consumer advocates said they were pleased with some of the measures that the Fed included. “This rule contains a lot of commitments to be tougher,” said Marcus Stanley, policy director at Americans for Financial Reform, a group that has lobbied for tougher financial regulation.
But they said the Fed had taken steps to protect its latitude to act. “The rule still has very extensive Federal Reserve discretion in it,” Mr. Stanley said.
And consumer advocates say the rule could yet allow seriously stressed firms to borrow from the Fed. While the Fed may offer a loan to many firms, one or two banks that are in desperate need may benefit the most from the Fed’s assistance, effectively obtaining a bailout on the sly. In 2008, for instance, a handful of potentially insolvent banks might have collapsed had they not borrowed many billions of dollars from the Fed’s emergency facilities.
One challenge for the rule is that solvency can be a hard-to-determine concept, particularly in a crisis.
The new rule seeks to add some definition in this area. It says the Fed must obtain evidence that borrowing firms are not insolvent. One way in which a firm would be considered insolvent is if it were “generally not paying its undisputed debts” for 90 days. But there may still be gaps even here. In the lead-up to its rescue, A.I.G. was actively disputing the demands for payment coming from its trading partners. As a result, under this definition of insolvency, it might be able to argue that it was solvent.
In theory, other parts of Dodd-Frank have reduced the likelihood that the Fed will have to extend emergency loans. Banks have bolstered their balance sheets in several ways that make them more resilient to shocks. They are, for instance, less reliant on types of financing that the Fed’s loans temporarily replaced in 2008. Dodd-Frank also set up a procedure for killing off a dying bank in a way that seeks to minimize the panic that can occur when a large firm fails.
Still, the Fed may not have heard the last from members of Congress on its emergency lending powers. Senator Warren said in an emailed statement that she was glad that the Fed incorporated some aspects of her bill in the final rule. “But there are still loopholes that the Fed could exploit to provide another backdoor bailout to giant financial institutions,” she said. “It’s up to Congress to close those loopholes.”
A version of this article appears in print on December 1, 2015, on page B7 of the New York edition with the headline: Fed Approves a Rule Curbing Its Emergency Lending Power.