On Nov. 30, 2015, the Federal Reserveapproved a new rule, or so-called Final Rule, restricting emergency lending to big banks during a future crisis. This rule restricts the ability of the central bank to pump money into struggling companies.
The rule is supposed to address concerns by legislators and critics of the central bank who believe that the Fed possessed too much latitude to inject money into the financial system. The Fed is a lender of last resort, but in the aftermath of the 2008 financial crisis, many observers said that it operated without sufficient limits. The new rule allows the Fed to help an industry or market but not individual institutions such as the big banks it supported as the financial services sector teetered near collapse.
The rule mandates that in every Federal Reserve lending program that at least five organizations should be eligible for participation. The Fed will require that an organization has enough collateral to protect taxpayers.
Reaction from Congress was lukewarm. A number of lawmakers from both major parties think that the Fed could have gone further. Below are answers to five questions about the new rule.
What is emergency lending?
Until the 2008 financial crisis, Section 13(3) of the Federal Reserve Act allowed the central bank to make emergency loans. The Federal Board had the authority to allow any of the state Federal banks to extend credit to "any individual, partnership, or corporation" in "unusual and exigent circumstances." But following the 2008 financial crisis, the function of a "lender of last resort"(LOLR) was heavily criticized for its weak structural framework and execution policies. According to Forbes, the Fed lent more than $16 trillion through broad-based emergency lending programs from December 2007 to July 2010.
How was the issue addressed post 2008?
In 2010, the Dodd- Frank Act introduced several rules to bring more clarity and transparency to the financial system. Title XI of the Act restricted the Fed's ability to provide emergency loans during a financial crisis. It made amendments to Section 13(3) of the Federal Reserve Act allowing the Fed to make emergency loans to only "broad-based eligibility" programs. This meant a restriction on lending to individual and insolvent firms.
What is the new rule in Emergency Lending?
The new rule includes changes that will restrict bailouts for big banks. The rule will be in effect from Jan. 1, 2016 and limits the "number of firms" and the "kind of firms" that should be given emergency funding.
The new rule restricts the number of firms that can receive emergency funding to five. The revised rule also attempts to make the lending procedure more transparent. Banks that are already declared bankrupt or are "insolvent from an accounting or other perspective" will not receive emergency funds during times of crisis.
Which banks may be affected by the new rule?
Emergency funding for big banks will be affected. Credit rating agency, Standard & Poor's has already downgraded the credit ratings of some of the largest banks, calling the likelihood of government support to the banks "uncertain."
The banks included in the downgrade were Goldman Sachs, Citigroup, Morgan Stanley and Bank of America, which were placed three notches above "junk" status by the credit rating agency. Also included in the downgrade were Wells Fargo, JP Morgan, State Street and Bank of New York Mellon.
Is the new rule sufficient to address the "too big to fail" problem?
Financial Services Committee Chairman Jeb Hensarling (R-Tex.) in a press release, criticized the new rule and said that "too-big-to-fail" organizations continue to exist even after the implementation of the Dodd-Frank law. He added, "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.'"
The new rule has also been criticized by Senator Elizabeth Warren. She told CNN Money, "There are still loopholes that the Fed could exploit to provide another back-door bailout to giant financial institutions."
Yet in a statement, Fed Chair Janet Yellen defended the Fed's actions. Although the final rule may not fully address the issue of too big to fail, it significantly restricts the process of emergency loans which was extended recklessly to any firm in 2008. In a press release, Federal Reserve Chair Janet Yellen emphasized the importance of emergency lending by adding that, "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."
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.