One of the enduring criticisms of the Dodd-Frank Wall Street Reform Act of 2010 is that it codifies “too big to fail” and allows the government to continue to financially rescue firms that are deemed systemically important.
The Federal Reserve changed that on Monday by approving a final rule that would prevent the government from the same type of emergency lending to institutions that are “too big to fail” in which it engaged in 2008, costing taxpayers billions of dollars.
“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,” Fed Chairman Janet Yellen said. “The Federal Reserve has long had this authority but has used it only sparingly and only in severe financial crises.”
Dodd-Frank limited the Fed’s ability to engage in emergency lending to programs and facilities with “broad-based eligibility” as approved by the Secretary of the Department of Treasury. It also prohibits the Fed’s ability to lend to insolvent entities.
The new final rule contains a number of changes to the original proposed rule, based on comments received. Under the final rule, the term “broad-based” is defined as a program or facility not designed for the purpose of aiding failing firms, and a program or facility in which five entities would be eligible to participate, according to the Fed. The limitations to the term “broad-based” are consistent with Dodd-Frank revisions that state a program should not exist for the purpose of aiding a specific company with avoiding bankruptcy, the Fed said.
The final rule provides clarification to the Fed’s implementation of the limitations imposed on emergency lending by Dodd-Frank. Since Dodd-Frank contains a provision that prohibits the Fed’s ability to lend to insolvent entities, the final rule broadens the definition of “insolvency.” The definition has been expanded to include borrowers who fail to pay undisputed debts as they become due 90 days before borrowing—or borrowers who are determined to be insolvent by the Fed or lending Reserve Bank.
According to the Fed’s announcement, commenters on the rule prior to its final approval had urged the Fed to expand its definition of insolvency to include companies that had not yet formally declared bankruptcy or entered resolution proceedings, but are insolvent from an accounting standpoint.
The final rule, just as in the proposed rule, includes Dodd-Frank’s requirement that all emergency lending programs must be approved by the Treasury Secretary, and the Fed must find before authorizing any emergency credit programs that “unusual and exigent circumstances” exist in the company.
Whereas the Fed’s practice in emergency lending has always been to set the interest rate at a level that encourages the borrowers to repay the credit as quickly as possible, the final rule (changed from its original proposal) requires the interest rate for emergency credit extended under Section 13(3) of Dodd-Frank to be set at a level that:
- is a premium to the market in normal circumstances
- affords liquidity in unusual and exigent circumstances;
- and encourages repayment along with discouraging the use of emergency credit under Dodd-Frank Section 13(3) as economic circumstances normalize.
“The ability to engage in emergency lending through broad-based facilities to ensure liquidity in the financial system is a critical tool for responding to broad and unusual market stresses,” Yellen said. “We have received helpful and constructive comments from many sources on a rule to implement these Dodd-Frank Act provisions. 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. Some industry professionals were left to wonder why such a rule is necessary, since Dodd-Frank's original intent was to prevent 'too big to fail'-type bailouts.
"The Fed and other federal agencies have been telling us for quite some time that Dodd-Frank legislation was intended to eliminate the scenario of 'Too Big to Fail,' but apparently it did not, or the Fed simply wouldn’t see the need to introduce a final rule on emergency lending,” Five Star President and CEO Ed Delgado said. "This latest rule will likely turn out to be much ado about nothing. While the clarification of 'broad-based lending’ is designed to limit the types of bailouts the industry realized in 2008, at the same time, the Fed expanded the definition of ‘insolvency’ ostensibly, given the circumstance, permitting lending to entities that may actually be insolvent, so I question how much of an impact this new rule will really have?"
U.S. Rep. Jeb Hensarling (R-Texas), Chairman of the House Financial Services Committee, was also skeptical that the new rule would actually stop the government from bailing out large financial firms.
“Five years after Dodd-Frank became law, ‘too big to fail’ is unfortunately alive and well and this rule from the Federal Reserve doesn’t change that,” Hensarling said. “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.’ Emergency lending should not mean discretionary lending. It should not mean the unaccountable and unelected in Washington pick winners and losers. Vague rules and bureaucratic discretion are not the answer—they are the problem. Instead, Congress can take a crucial step in preventing future bailouts by approving the House-passed FORM Act. The FORM Act places needed constraints on the Fed’s emergency lending powers. It restricts emergency loans to financial institutions only and makes sure they are provided at a ‘penalty rate’ so banks are not improperly subsidized. The FORM Act injects greater accountability into the system by requiring not only a supermajority of Federal Reserve governors but also a supermajority of district bank presidents to approve any emergency loan. By enacting these reforms, Congress can provide assurances to taxpayers that they will not have their pockets picked the next time the Fed decides to bail out a financial institution it decides is ‘too big to fail.’”
Editor's note: The Five Star Institute is the parent company of DS News and DSNews.com.