While the Federal Reserve came to the aid of firms such as American International Group, Inc. AIG and JPMorgan Chase & Co. JPM during the 2008 financial crisis by providing individual loans, the new rule approved yesterday by the Fed officials will prohibit it from doing so in the future.
Under the new rule, the Fed will be able to utilize its emergency lending authority only to aid an entire market or sector of the economy, instead of particular firms. In short, the new rule will prevent the Fed from bailing out individual companies like it has done in the past.
Details
The new rule, which was required by the 2010 Dodd-Frank financial reform law, states that the Fed's authority to engage in emergency lending has been limited to programs and facilities with "broad-based eligibility" and prohibits lending to entities that are insolvent and imposes certain other limitations.
The Fed’s new lending program is required to be broad enough so that it can be used by at least five companies in contrast to the customized efforts previously undertaken for individual firms. The Fed is now restricted to providing emergency loans to individual companies and to insolvent companies, which are defined as those that had failed to pay "undisputed debts" in the previous 90 days.
The Fed Chairwoman Janet Yellen said, “In the Dodd-Frank Act, Congress reviewed the scope of the Federal Reserve's emergency lending authority and determined to make significant modifications that enable the Federal Reserve to extend emergency credit only through broad-based facilities and programs designed to provide liquidity to the financial system. The Dodd-Frank Act amendments eliminated the authority to lend for the purpose of aiding a failing firm or preventing a firm from entering bankruptcy or another resolution process, such as was done with loans to Bear Stearns and AIG.”
Benefits
During the financial crisis, the Fed approved loan guarantees to help JPMorgan limit probable losses from purchasing Bear Stearns, which was on the verge of a collapse. Also, the Fed bailed out American International Group from a potential failure.
Banks like Citigroup Inc. C and Wells Fargo & Company WFC, which were in trouble at the time of crisis, also received government aid. However, Lehman Brothers was not offered help as it was deemed insolvent and as a result could not be salvaged.
While the new rule will help put an end to the "too big to fail" tag associated with certain major individual financial companies, it will also put some restrictions on the Fed, which is said to have had too few limitations when it tried to keep big banks and other firms afloat during the 2008 financial crisis.
Road Ahead
The Fed’s actions during the crisis earned the central bank $30 billion in net profits, according to a September Congressional Research Service review, quoted by Reuters. However, the lawmakers believe that the Fed should lend to banks on a short-term basis to smoothen the operations of the financial system as required, rather than overreaching companies in trouble.
This will help managers avoid undue risk-taking during troubled times due to their expectations of bailouts, instead of taking measures to turn their companies around in times of stress.
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