The Federal Reserve Board Approves Cut to Its Emergency Lending Powers

“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 US economy”, said Fed Chairwoman Janet Yellen, in a statement, noting that the Fed had used its powers “sparingly”.

The Federal Reserve its scrapping its policy aimed at preventing companies that are “too big to fail” from collapsing. Detractors have characterized emergency lending as “backdoor bailouts”, citing the $710 billion in lending the Fed provided during the financial crisis.

“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.

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.

The rule would require that new lending programs be designed broadly enough that at least five potential recipients could be eligible for loans. The limitations to the term “broad-based” are consistent with Dodd-Frank revisions that state a program should not exist for the objective of aiding a specific company with avoiding bankruptcy, the Fed said. The final Fed rule is scheduled to be implemented on January 1, 2016. The Fed would also be prohibited from giving loans to solvent companies that would then be passed on to insolvent ones.

Borrowers that had failed to pay “undisputed debts” in the previous 90 days will also not qualify for loans. “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 routinely lends money to banks on a short-term basis to smooth the operations of the financial system, which is part of its mandate. “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”.

Not everyone received the news of the final rule with enthusiasm.

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. “These changes will help promote market discipline and make the financial system safer-but there are still loopholes that the Fed could exploit to provide another back-door bailout to giant financial institutions”, she said.