The Fed's Forever Bailout

In the Dodd-Frank financial reform law, Congress tried to put some minimal restrictions on the Federal Reserve’s powers to bail out Wall Street – but it doesn’t look like the Fed is interested in cooperating. Three years after the agency was instructed to specify new bailout rules “as soon as practicable,” the Federal Reserve still hasn’t done so.

The moral hazard created by bailouts for irresponsible financial behavior is an issue central to financial reform. During the 2008 crisis, the federal government provided unprecedented amounts of assistance to Wall Street, and provided it on extraordinarily favorable terms. The $750 billion Troubled Asset Relief Program authorized by Congress got the most attention, but TARP was just the tip of the iceberg.

Almost a year before TARP, the Federal Reserve began to use its emergency powers under Section 13(3) of the Federal Reserve Act to provide low-interest loans to Wall Street. Over the two years from 2007 to 2009, some $16 trillion in emergency lending flowed through Federal Reserve facilities. At the peak of the Federal Reserve’s emergency bailout, some $1.5 trillion per day was being loaned to various Wall Street and foreign banks.

The Federal Reserve’s use of its emergency powers went far beyond any historical precedent. Section 13(3) of the Federal Reserve Act, which permits the Federal Reserve to do emergency lending to businesses under “unusual and exigent circumstances,” was passed in 1932 during the depths of the Depression. The context differed profoundly from today – for example, policymakers were concerned that in some regions with extensive bank failures, businesses might lack banking services altogether. The original 13(3) also contemplated that emergency powers could be used to lend directly to businesses, instead of simply to financial interests. But even during the Great Depression, the use made of these emergency powers was strictly limited, with less than $2 million in loans made over four years.

While it’s somewhat accepted for central banks to provide some emergency assistance during times of financial stress, the Federal Reserve’s use of its emergency powers went well beyond normal principles of central banking.  Since the 19th century, those principles have called for lending on a temporary basis and at a “penalty rate” – that is, at an interest rate above the prevailing market rate.

The use of a penalty rate means banks which need assistance would have an incentive to self-cure and would bear part of the costs of their rescue. As researchers have documented, the Federal Reserve blatantly violated these principles, extending massive loan programs for a period of years and providing heavily subsidized assistance at rates far below the market rate.

In a compromise, the Dodd-Frank law permitted the Federal Reserve to retain broad emergency lending powers, but placed new limitations on their use. Under Section 1101 of the law, emergency lending must be secured by good collateral and may only be performed through programs with “broad based eligibility” that are limited to “solvent” companies and are not designed to assist a single failing bank. Lending programs also must be terminated in a “timely” manner.

While the restrictions sound good in theory, the legislative language is far too broad and vague to provide an effective check on the Federal Reserve’s emergency powers. The meaning of a “solvent” institution or “good collateral” is often in the eye of the beholder. And a program with “broad based eligibility” can easily be structured to be especially beneficial to holders of a selected class of assets – for example, a program that allowed financial institutions to convert toxic securities into cash could be seen as “broad based,”  since anyone holding such securities would be eligible.

For that reason, Section 1101 also required the Federal Reserve and Treasury to immediately write regulations setting out the exact policies and procedures governing its emergency lending programs. In fact, the Fed was required to propose these regulations “as soon as is practicable.”

But the Federal Reserve seems to be simply ignoring this requirement. Today, three years after the bill was enacted, regulations still haven’t been proposed. The delay isn’t because good rules would be particularly complicated to write. For example, a restriction on emergency lending to a strictly limited time period – say, 90 days – would automatically tend to restrict assistance to financial entities which are actually solvent and have good collateral. That’s because a solvent institution that faces temporary liquidity problems due to market disruptions should be able to find private sector funding over a relatively short time period, while a truly insolvent institution could not.

Clear and forceful rules to limit future Federal Reserve bailouts are necessary to address the expectations created by recent experience that the government may pick up the tab for irresponsible Wall Street behavior. Unfortunately, the Federal Reserve’s inaction on these rules undermines confidence that it’s serious about obeying the new restrictions. It’s past time for them to put the rules in place. Sens. Sherrod Brown, D-Ohio,  and David Vitter, R-La., have introduced new legislation that – along with significantly increasing capital requirements for big banks – would also place far stronger limitations on Federal Reserve emergency assistance. The longer the Federal Reserve delays, the stronger the case looks for doing so.

  — Marcus Stanley

Originally published on


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