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Central Bank

Too Big to Fail vs. Too Handcuffed to Act

Too Big to Fail vs. Too Handcuffed to Act

Mistrust of the Federal Reserve makes strange bedfellows. Representative Scott Garrett (R-N.J.) received a 100 percent score from the American Conservative Union last year, while Senator Elizabeth Warren (D-Mass.) earned 4 percent. Yet the two have found common cause on one issue: restricting the Fed’s freedom to lend to troubled banks in the next financial crisis. “If the board’s emergency lending authority is left unchecked, it can once again be used to provide massive bailouts to large financial institutions without any congressional action,” says an Aug. 18 letter to Fed Chair Janet Yellen signed by Garrett and Warren, along with five other congressional Republicans and eight Democrats.

Sounds sensible: Who wants the Federal Reserve picking and choosing which zombie banks to rescue? But there’s another side to the story. If the Fed faces tight limits on lending in the next crisis, it might not be able to stop a panic that could drag down fundamentally solvent financial institutions with short-term financing problems. The unnecessary failure of those banks would damage the economy and raise the cost of a government rescue. That’s the counterargument made in a report scheduled for release on Sept. 4 by the Bipartisan Policy Center, a Washington advocacy group. The report’s authors include Peter Fisher, a former senior official at the Department of Treasury who until early last year was head of fixed income at BlackRock (BLK), the world’s largest asset manager. “We’re eager to do something about too big to fail, but tying the Fed’s hands is not the right way to go,” Fisher says.

The skirmishing is coming to a head because the Fed is considering the final version of a rule governing its own emergency lending, one of many rules required by the 2010 Dodd-Frank Act. The Fed put out a version of its rule for comment last December but hasn’t issued the final one because of sharp disagreements in Washington over how much discretion the Fed should have.

The preliminary rule specifies that offers of aid by the Fed must be broad-based and “not for the purpose of aiding a failing financial company.” Its language isn’t tight enough for Warren and her fellow letter writers. Among other things, they want the Fed to establish a clear time limit for a financial institution’s reliance on emergency lending, and they want it to lend at a “penalty rate”—i.e., a higher rate, not a lower one than is available to safe borrowers. And because the central bank isn’t allowed to lend to insolvent institutions, the lawmakers want the Fed to adopt a broader definition of insolvency so that it is prevented from lending to shaky banks that should be shut down.

Fisher, now a senior lecturer at Dartmouth College’s Tuck School of Business, and his co-authors argue that the Fed’s flexibility in 2008 kept the financial crisis from being worse. One-off loans to American International Group, then the world’s biggest insurer, prevented AIG’s collapse, they say, adding that such loans would probably not be allowed under Dodd-Frank.

The Bipartisan Policy Center urges Congress to repeal the Dodd-Frank provision that requires the Federal Deposit Insurance Corp. to get approval from Congress before it can quell a panic by guaranteeing all liabilities of banks, not just deposits. Such a blanket guarantee was crucial to preventing a run in 2008. And they say that broker-dealers (such as Merrill Lynch) should have as much access to emergency funds as commercial banks (like Bank of America (BAC), which owns Merrill).

Fisher became a director of AIG this year, while both of his co-authors, Cantwell Muckenfuss and former Comptroller of the Currency John Dugan, have lobbied for banks. But Fisher says the report isn’t a brief for the financial sector. “Let the recommendations stand on their merits,” he says. “We’ve all got a lot of scar tissue on what’s gone wrong and what’s gone right over the past 20 years.” They’re right about one thing: If the Fed and the FDIC can’t stave off a chain reaction of financial institution failures in the next crisis because their hands are tied, that part of Dodd-Frank will look like a costly mistake.

The bottom line: Efforts to keep the Fed from propping up zombie banks could limit its ability to fight financial crises.

Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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