New Fed Rule Limits Emergency Lending Power

1 Dec 2015 | Author: | No comments yet »

Fed Limits Future Emergency Lending Programs.

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 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 restrictions, which stem from the Dodd-Frank Act of 2010, aim to make sure that the Fed’s emergency loans are not used to shore up insolvent firms. The Fed spent about $2 trillion on such a program to ease a credit crunch during the financial meltdown, aiming to spark lending to consumers and small businesses. 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 changes stem from legislation passed in 2010 under the sweeping Dodd-Frank banking reform bill, which was created in an effort to ward off another financial crisis and to avoid another massive taxpayer financed bailout of the financial industry. 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.

First, it forbid loan facilities directed at specific firms or a number of specific failing firms, requiring rescue funds be limited to “broad-based.” That rules out the targeted lending the Fed undertook in its rescue of AIG and related to the sale of Bear Stearns to J.P. Under Dodd-Frank the Fed was prohibited from lending to ‘insolvent’ banks, and the new rules approved Monday provide a broader definition of ‘insolvent.’ Under the new rules, the Fed couldn’t lend money to any bank that had failed to pay “undisputed debts” in the past 90 days. 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. Yellen noted that to replace rescue loans to individual companies, the 2010 law outlines procedures for failing big financial firms to go through bankruptcy proceedings.

David Vitter to introduce legislation last May in an attempt to limit the Fed’s lending authority by requiring a minimum of five banks that meet the criteria to be involved in any central bank lending program — a provision set to be implemented under the finalized rule. “The Dodd-Frank Act amendments eliminated the authority to lend for the purpose of aiding a failing firm or preventing a firm from entering bankruptcy or another resolution process, such as was done with loans to Bear Stearns and AIG,” Yellen said in her opening statement. 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. 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. 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.

Jeb Hensarling of Texas, a conservative Republican who heads the House Financial Services Committee, said the Fed’s rule doesn’t go far enough because it still allows emergency lending at the Fed’s discretion. 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. The issue of limits on the government’s power in responding to financial catastrophe came to the fore in an unusual legal case over the Fed’s $85 billion bailout in September 2008 of then-teetering AIG. But the next crisis will be different than the last, and will inevitably involve new errors that cannot be fully known to have been errors until after the fact. “In the midst of that new crisis, if and when it comes, no rule adopted today will prevent those errors any more than it will prevent measures that on balance prove necessary and wise. “Today’s Fed decision, then, should be read as an admission by the Fed that it wasn’t perfect in 2008 and isn’t perfect now; but it should not be read as seriously constraining Fed flexibility going forward if and when a new crisis occurs.”

The bailout violated the Constitution’s Fifth Amendment by taking control of AIG with 80 percent of the stock without “just compensation,” Greenberg’s suit alleged. The government insisted that its actions in the AIG bailout were legal, proper and effective, and that the terms were as tough as needed to protect taxpayers from the risk of AIG failing to repay the loan. In reality, the rule might incentivize regulators charged with preserving financial stability to set up lending facilities earlier than they might otherwise. 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.

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.

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