The Fed's New Emergency Lending Rules: Not Far Enough, Not Surprising

COMMENTARY Markets and Finance

The Fed's New Emergency Lending Rules: Not Far Enough, Not Surprising

Dec 10th, 2015 5 min read
Norbert J. Michel, Ph.D.

Research Fellow in Financial Regulations

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

The Federal Reserve has just finalized its new rules for making emergency loans, as required by the 2010 Dodd-Frank Act. Supposedly, the authors of Dodd-Frank wanted to prevent the Fed from ever again making the kinds of emergency loans – relatively cheap ones to failing financial firms – that it made during the 2008 crisis.

The Fed initially proposed its rules in 2013, but several members of Congress felt the proposal fell short of what Dodd-Frank intended. To rectify the situation, Senators Elizabeth Warren (D-Mass.) and David Vitter (R-La.) introduced the Bailout Prevention Act of 2015, and the House passed the Fed Oversight Reform and Modernization Act of 2015 (the FORM Act), a measure which included new emergency lending restrictions.

As I’ve written before, it is great that Congress is focused on fixing the Fed’s emergency lending powers. The Fed has a long history of abusing this authority (under Section 13(3) of the Federal Reserve Act) both by lending at below market rates and propping up failing institutions.

But if lawmakers really want to end these kinds of bailouts, they won’t just curb the Fed’s emergency lending, they’ll get rid of it altogether. The Fed’s final rule does appear to be more restrictive than their original proposal; it’s very similar to the Warren-Vitter plan, but it still rests on the flawed notion that emergency loans are necessary.

The best solution is to let private markets determine who gets loans, even during a so-called crisis, and to limit the Fed to conducting monetary policy. In other words, restrict the Fed to providing system-wide liquidity, and let private firms allocate credit. (A key complimentary reform would be to dump the outdated primary dealer system for a system-wide auction facility.)

The Fed has no special knowledge of which companies are solvent. It does, however, have every incentive to dole out credit – liberally – if allowed to do so. But if the Fed does its job properly so that the system is full of liquidity, then the most likely reason a firm can’t get a loan is because lenders believe it could be insolvent.

It’s also possible that restrictive regulations prevent banks from making additional loans in a crisis, but the solution in that case is to remove the restrictions.

So far, though, Congress seems unwilling to eliminate the Fed’s 13(3) lending authority. Instead, lawmakers are trying to force the Fed to make these loans only to solvent firms, only at above-market rates, and only for a short period of time.

But what private financial institution would refuse to make loans on such terms?

Unless regulators prevent it from doing so, no firm would refuse to provide credit on these terms.

If we only want loans to go to solvent firms, we simply don’t need the Fed – or any other government agency – to make the loans.

Hesitancy to eliminate the Fed’s 13(3) lending authority is not really surprising, though. Public policies have been geared toward preventing bank failures for nearly a century. But the fear that a bank failure can cause a widespread economic disaster is overblown, based almost entirely on conjecture, and leads directly to taxpayers supporting failing financial firms.

The most important point supporting these arguments is that solvent banks don’t fail. Yes, illiquidity can cause insolvency if it drags on long enough, but if the Fed provides system-wide liquidity then we avoid this scenario.

So what about the Fed making emergency loans to insolvent banks, or to those of questionable financial health? Are these loans really necessary to prevent bank failures from turning into recessions or depressions?

The short answer is no. And the direct effects for a single bank failure are easy to parse out. (The analysis is comparable for widespread bank failures, and in such a case it’s even more likely that underlying economic problems caused the bank failures, as opposed to the other way around.)

Let’s look at who stands to lose money when a bank fails: its deposit customers, loan customers, employees, creditors, and owners.

Our current deposit insurance framework takes care of the deposit customers. And bank failures do nothing to change loan customers’ economic conditions. (They already have their loan, and the bank failure itself doesn’t increase the likelihood they’ll default on their loan.)

While certainly unpleasant, there is nothing special about bank employees that requires unique unemployment protection. They’re eligible for unemployment assistance just like everyone else.

Shareholders can easily be wiped out in a bank failure, but that’s the risk investors take when they buy equity in any company. There’s nothing unique here relative to a nonbank shareholder’s problem.

Virtually the same can be said for banks’ creditors except that they’re generally in a better position than shareholders. Creditors will typically lose some money in a bankruptcy, but they have a priority claim on the value of a failed firm’s assets.

In financial terms, it’s likely that the creditors will take a haircut, but unlikely they’ll lose all of what’s owed to them. It’s extremely unlikely that a failed banks’ assets will be worth zero.

Admittedly, indirect/secondary affects are more difficult to analyze, but those are the only ones that could lead to a recession or depression.

One obvious possibility is that shareholders and creditors hurt by a bank failure will be less willing to risk their capital in future investments.

But it’s far from clear that this scenario alone could cause an economic disaster. Aside from the virtual impossibility that there will be zero asset value left in the bank, credit markets are driven by both supply and demand.

In other words, the final amount of credit supplied in the economy depends on the interactions of those willing to supply credit and those seeking credit. Just like in a goods market, prices will reflect these interactions, and we will end up with a new aggregate credit amount at (possibly) new prices.

We’ve been conditioned against making this sort of analogy, but think of a company such as Wal-Mart. If Wal-Mart filed for bankruptcy, there would still be a need for the goods and services Wal-Mart provides. Absent major regulatory/legal restrictions, there’s every reason to expect other companies to fill the void.

We may very well pay different prices than originally offered by Wal-Mart, and some people may not have the exact quantities of goods and services they had before.

Some people will surely lose their jobs, but we would expect them to eventually find other employment as these new companies fill the gap left by Wal-Mart’s disappearance.

There’s no inherent reason to expect a different outcome in the financial industry.

-Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies. He is also a co-author of Heritage’s Opportunity for All; Favoritism to None.

This piece first appeared in Forbes. See the original and read more articles at