How the Fed Protected Its Bailout Powers

1 Dec 2015 | Author: | No comments yet »

Fed Limits Future Emergency Lending Programs.

The Federal Reserve on Monday managed to thread the needle on its emergency-lending powers, acknowledging legally mandated limits while preserving flexibility. By a unanimous vote, the Fed approved rules limiting lending to help specific “too-big-to-fail” firms that are in trouble as it did in the last financial crisis with loans to Bear Stearns and American International Group. The Fed’s board, led by chairman Janet Yellen, approved measures that included only being allowed to rescue at least five firms at a time, instead of single entities. The regulation puts a Dodd-Frank provision into effect requiring the central bank to limit emergency lending to facilities with “broad-based eligibility” instead of specific firms, preventing the Fed from providing loans to insolvent “too big to fail” companies. The new rules would allow for emergency lending only in the event of “broad-based” systemic issues affecting a number of banks rather than tailoring emergency loans to the individual needs of a single failing bank.

The rule, unanimously approved by the Fed’s Washington-based board in an open meeting, requires that any future emergency lending be only “broad-based” to address larger financial market problems, and not tailored to specific firms. The Fed’s lending to big Wall Street firms was controversial, and Congress moved quickly to restrict the practice in the sweeping Dodd-Frank bank reform law.

Fed Chair Janet Yellen defended bailouts in certain circumstances, sayings emergency lending is a “critical tool” used to mitigate potential economic crises which has only been used sparingly. The latter circumstance is known as “moral hazard,” and broad segments of the public and many politicians insisted that it be addressed in reforms established in the wake of the 2008 crisis. To avoid lending to insolvent companies, the regulations also said no loans would be made to firms that had failed to pay “undisputed debts” in the previous 90 days.

The feeling at the time was that executives at so-called ‘too big to fail’ banks knew the government would have to bail them out so they cavalierly took on dangerous amounts of risk in order to increase their firms’ profits and their own paychecks in the process. Fed Governor Daniel Tarullo said during the meeting that the regulations would provide better balance between the Fed’s need to respond in a crisis and the concern that helping specific companies considered “too big to fail” created the wrong incentives for managers at companies expecting to be bailed out.

There has been “a longstanding tension of confronting moral hazard with wanting to retain flexibility,” said Tarullo, the Fed’s point person on regulatory issues. As credit markets froze up in 2008 following the collapse of the U.S. housing market, several huge lenders and financial institutions including Bear Stearns, AIG (NYSE: AIG) and Citigroup (NYSE: C) teetered on brink of collapse, prompting the Fed to open its little-used “emergency lending window.” The move may have averted a much larger crisis but critics have argued that the big banks were bailed out by the government despite their risky behaviors brining on the crisis in the first place. The loans have been repaid and the guarantees ended, ultimately earning the Fed a net profit of $30 billion, according to a September Congressional Research Service review.

However the effort was criticized as overreach, arguably important in limiting the crisis but also not clearly in line with the intended use of the Fed’s emergency authority. In reality, the rule might incentivize regulators charged with preserving financial stability to set up lending facilities earlier than they might otherwise. The Dodd-Frank reforms reined in those powers, and the rules approved on Monday put those Dodd-Frank provisions into effect. (Reporting by Howard Schneider; Editing by Meredith Mazzilli, Andrea Ricci and Nick Zieminski)

But the fact the Fed had to go through this exercise in response to congressional outrage about bailouts will likely mean future emergency funds will come with steep price tags.

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