Another AIG-Style Fed Bailout Is About to Become Less Likely

Senate Banking Hearing On Equity Market Structure And Electronic Trading

After the Fed released an initial proposal almost two years ago, a bipartisan group of lawmakers including Democratic Senator Elizabeth Warren complained that it didn’t go far enough.

Photographer: Andrew Harrer/Bloomberg
  • Emergency lending rule reflects tug-of-war with Congress
  • Yellen reluctant to cede rescue flexibility in case of crisis

The Federal Reserve is on the verge of relinquishing the tools it used to rescue American International Group Inc. and Bear Stearns Cos. That probably won’t appease lawmakers who’ve said they’re still concerned the central bank might abuse its powers as the lender of last resort.

The Fed is required to write rules that eliminate some of its sweeping emergency lending authority and plans to complete the long-delayed regulations by the end of this month. The measure stems from the 2010 Dodd-Frank law, which limited the Fed’s ability to prop up banks.

But after the Fed released an initial proposal almost two years ago, a bipartisan group of lawmakers including Democratic Senator Elizabeth Warren complained that it didn’t go far enough and left regulators too much wiggle room to orchestrate a backdoor bailout that violates the intent of Congress. Yellen, testifying before a House panel this month, rejected the idea that the Fed should relinquish its role as potential savior in a crisis.

“We regard our emergency lending powers as very crucial,” Yellen told the House Financial Services Committee on Nov. 4. The Federal Reserve was created to “provide liquidity when there’s a financial panic,” she added.

The debate is part of Yellen’s tug-of-war with a Congress that wants to rein in the Fed’s influence over the U.S. economy and financial system. 

Reckless Behavior

Warren and other lawmakers argue the expectation that the Fed will rescue failing banks, incentivizes reckless behavior on Wall Street. Lawmakers also are trying to shrink the number of banks that receive heightened supervision from the Fed and are threatening to boost Congress’ authority over the Federal Reserve Bank of New York, which oversees giant U.S. lenders such as JPMorgan Chase & Co. and Citigroup Inc. Republicans led by Senate Banking Committee Chairman Richard Shelby want the Fed to disclose more information about its decisions on setting interest rates.

“The Fed is trying to preserve as much of its power as it can, in part because that’s what institutions do, but also because they believe they should retain flexibility” to stabilize the banking system in a crisis, said Satish Kini, chair of the banking group at law firm Debevoise & Plimpton LLP and a former lawyer at the Fed.

Fed spokesman Eric Kollig declined to comment on the lending rule.

Before Dodd-Frank, the central bank had the authority “in unusual and exigent circumstances” to lend to virtually any company or person, thanks to section 13(3) of the Federal Reserve Act. In March 2008, the Fed, then led by Ben S. Bernanke, used that power to extend credit to Bear Stearns through JPMorgan, which acquired the failing securities firm. Six months later the Fed began a bailout program to keep insurer AIG afloat.

Now the Fed is prohibited from rescuing individual firms, but Dodd-Frank permits the central bank to provide “broad-based” liquidity to the financial system if it gets the approval of the Treasury secretary. The Fed can continue to lend through the discount window, where banks borrow when money is tight, and it can increase liquidity by purchasing U.S. Treasuries and federal agency securities.

Though Dodd-Frank laid out the basic emergency lending restrictions, the Fed has to write the policies and procedures. Its December 2013 proposal was criticized by 15 lawmakers who told Yellen in a letter that the plan “places no meaningful restrictions on its emergency lending powers.” The group was led by Warren of Massachusetts and Republican Senator David Vitter of Louisiana.

Moral Hazard

The lawmakers urged the Fed to revise its proposal to establish both clear time limits for how long banks could receive emergency lending and procedures for the orderly unwinding of such programs. They asked Yellen to improve how the Fed defines terms such as insolvent and broad-based. To prevent the so-called moral hazard associated with the Fed’s lending authority, the group requested that any emergency loans be made at unfavorable, or penalty, interest rates.

Yellen has indicated that she might partly, but not entirely, appease the politicians. The Fed expects to release the final rule by the end of November and will address “concerns about the definition of broad-based eligibility, insolvent borrowers, and penalty rates,” she told the House panel. She didn’t discuss the lawmakers’ other requests.

Yellen also must contend with Republican efforts led by Shelby to limit the Fed’s authority. Legislation he drafted that would reduce Fed oversight of regional banks, including eliminating stress tests for many of them, was added to a spending bill that Congress must pass next month to avert a federal government shutdown.

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