Former Fed Chair Says Restricting Central Bank’s Lending Power is a ‘Mistake’

Former Federal Reserve chairman Ben Bernanke has voiced his displeasure with the provisions of a bi-partisan bill introduced in the Senate earlier this week that would limit the Fed's lending authority and end "too big to fail."

On his Brookings Institution blog on Friday, Bernanke, who was chairman of the central bank from 2006 to 2014, said that limiting the Fed's lending power during economic downturns as called for by the Bailout Prevention Act introduced by Senators Elizabeth Warren (D-Massachusetts) and David Vitter (R-Louisiana) "would be a mistake, one that would imprudently limit the Fed's ability to protect the economy in a financial panic."

The Warren-Vitter bill came out of the belief on the part of the two Senators that the Fed's proposed rule did not do enough to limit the central bank's lending authority as required by the Dodd-Frank Act. Warren, Vitter, and 13 other Senators wrote a letter to the Fed last August asking the bank to revisit this issue, and the lawmakers do not believe the Fed has sufficiently acted in the nine months since.

Bernanke contends that Dodd-Frank created a so-called "liquidation authority" which eliminated the Fed's ability to bail out firms such as Bear Stearns and AIG, firms in whose cases the Fed intervened with "great reluctance." He said during 2007 to 2009, at the height of the crisis, the Fed exercised its lending authority in two ways – bailing out Bear Stearns and AIG, two systemically critical firms, fearing that the failure of these firms would create a domino effect; and second, creating a variety of broad-based lending programs "to unfreeze dysfunctional markets and to help stem devastating runs that left whole sectors of the financial system without adequate funding."

Two additional requirements imposed by the Bailout Prevention Act on the Fed's broad-based lending programs are, according to Bernanke: first, requiring a firm's solvency to be certified by the Fed and the supervisors of the firm before receiving any loans; and second, requiring emergency loan interest rates to be at least 5 percentage points higher than the Treasury Department's rate.

"Superficially, the two new conditions that Warren-Vitter would impose seem consistent with (19th Century English economist Walter) Bagehot's dictum, to lend freely at a penalty rate against good collateral," Bernanke said. "Unfortunately, in practice, they would eliminate the Fed's ability to serve as lender of last resort in a crisis."

Bernanke was surprised the Bailout Prevention Act was brought about by Warren, who has been a vocal supporter of Dodd-Frank and the chief architect of one of the lasting symbols of Wall Street reform, the controversial Consumer Financial Protection Bureau.

"It is puzzling that she would propose legislation to overturn one of the key legislative bargains in that bill—the trade of liquidation authority for reduced emergency powers—by further reducing the nation's ability to defend against financial panics," Bernanke said.

Bernanke said the problem in this case is what economists call a "stigma" of borrowing from the central bank, a problem that he said the Bailout Prevention Act will only exacerbate, creating an "insuperable stigma problem" by publicly identifying potential borrowers in solvency analyses, thus discouraging firms from becoming potential borrowers for fear that inferences will be drawn about the firm's financial health. The stigma problem will be further worsened by the 5 point percentage penalty rate removing all doubt that the borrowing firm cannot access any other funding sources, Bernanke said.

"I don't think Senators Vitter and Warren mean to stop broad-based emergency lending in all circumstances, although their bill would have that effect," Bernanke said. "Their goal, I assume, is to induce financial firms and market participants to be less reliant on possible government help, for example, by holding more cash to protect against possible runs and panics. But their approach is roughly equivalent to shutting down the fire department to encourage fire safety; or—more relevant to the current context—eliminating deposit insurance so that banks will be more careful. Rather than eliminating the fire department, it’s better to toughen the fire code."