Amid pressure from Congress to rein in its power to prop up a troubled financial institution, the Federal Reserve did just that Monday, adopting a new rule that will limit its ability to bail out failing financial institutions.
The Fed announced Monday that its board of governors approved a final rule for its “emergency lending” program, criticized by some as establishing that there are some banks that are simply “too big to fail.”
Under the new rule, the Fed will no longer conduct “emergency lending” to specific companies. Rather, under the new rules, the Fed said that it will now only consider emergency lending for “broad-based” problems, affecting larger market troubles.
Previously, since the passage of the Dodd-Frank Act in 2010, the Fed’s authority to provide “emergency lending” to a failing financial institution has been limited to programs and facilities with "broad-based eligibility" that have been established with the approval of the Secretary of the Treasury.
But the new rule defines “broad-based” to be an emergency lending program that “at least” five financial entities would be eligible to participate in.
In layman’s terms, that means no more direct bailouts to “too-big-to-fail” banks. Under the new Fed rules, if five financial entities aren’t concurrently failing, there are no bailouts.
On the other hand, the Fed’s new rule does leave the window open to future bailouts – a fact that Financial Services Committee Chairman Jeb Hensarling, R-TX, finds concerning.
“Five years after Dodd-Frank became law, ‘too big to fail’ is unfortunately alive and well and this rule from the Federal Reserve doesn’t change that,” Hensarling said in a statement.
“Indeed, by leaving the door wide open to future taxpayer-funded bailouts, this final rule compounds the moral hazard problem that lies at the core of ‘too big to fail,’” Hensarling continued.
“Emergency lending should not mean discretionary lending,” he said. “It should not mean the unaccountable and unelected in Washington pick winners and losers. Vague rules and bureaucratic discretion are not the answer – they are the problem.”
In its announcement, the Fed said that the new rules are “consistent with and provide further support to the revisions made by the Dodd-Frank Act that a program should not be for the purpose of aiding specific companies to avoid bankruptcy or resolution.”
The Fed’s new rules also further prohibits bailouts to entities that are insolvent.
“For this purpose, the final rule also broadens the definition of insolvency to cover borrowers who fail to pay undisputed debts as they become due during the 90 days prior to borrowing or who are determined by the Board or lending Reserve Bank to be insolvent,” the Fed said in its announcement. “Commenters urged the Board to adopt a broad definition of insolvency that includes situations where a company has not yet entered formal bankruptcy or resolution proceedings, but may be insolvent from an accounting or other perspective.”
The Fed also said that its new rule incorporates the requirement in the Dodd-Frank Act that the Secretary of the Treasury also must approve all Fed emergency lending programs.
The Fed said that it must still find that "unusual and exigent circumstances" exist as a pre-condition to authorizing emergency credit programs.
"Emergency lending is a critical tool that can be used in times of crisis to help mitigate extraordinary pressures in financial markets that would otherwise have severe adverse consequences for households, businesses, and the U.S. economy," said Fed Chair Janet Yellen.
But Hensarling said that the potential for another Fed bailout only furthers the need for comprehensive Fed reform.
“Congress can take a crucial step in preventing future bailouts by approving the House-passed FORM Act,” Hensarling said.
“The FORM Act places needed constraints on the Fed’s emergency lending powers. It restricts emergency loans to financial institutions only and makes sure they are provided at a ‘penalty rate’ so banks are not improperly subsidized,” Hensarling continued.
“The FORM Act injects greater accountability into the system by requiring not only a supermajority of Federal Reserve governors but also a supermajority of district bank presidents to approve any emergency loan,” Hensarling said. “By enacting these reforms, Congress can provide assurances to taxpayers that they will not have their pockets picked the next time the Fed decides to bail out a financial institution it decides is ‘too big to fail.’”