For all the ink spilled on TARP — the bailout package authorizing the Treasury to purchase or insure up to $700 billion of "troubled assets" during the financial crisis — that program is dwarfed by another market intervention that occurred around the same time. In fact, the Government Accountability Office estimates that the Federal Reserve lent more than $16 trillion to financial firms between December 2007 and July 2010 — a figure that comes close to matching the entire, annual gross domestic product of the United States.
On Wednesday, Cato's Center for Monetary and Financial Alternatives hosted a two-part discussion of the Federal Reserve's emergency lending power, and the legislative efforts underway to reform it. The first panel saw the Washington Post's Ylan Mui interview Phillip Swagel, a former Treasury official turned University of Maryland professor, Marcus Stanley, the policy director at Americans for Financial Reform, and Mark Calabria, Cato's own director of financial regulation studies. United States Senators Elizabeth Warren (D-MA) and David Vitter (R-LA) joined us for the second panel, during which they outlined their proposed "Bailout Prevention Act of 2015," as well as their broader, bipartisan quest to end "too big to fail."
As the participants in our first panel explained, the Fed's emergency lending is governed by Section 13(3) of the Federal Reserve Act. At the time of the financial crisis, this gave the Fed broad authority to lend to "any individual, partnership or corporation" in "unusual and exigent circumstances" so long as "other banking institutions" were not prepared to pony up the cash. The Dodd-Frank Act of 2010 tried to temper this unbridled discretion, introducing a sensible requirement that the Fed only lend to solvent institutions as part of a broad-based program of market support. Alas, the devil proved to be in the detail — or, rather, the lack thereof.
The legislative intent in Dodd-Frank was clear enough: the Fed should intervene when a lack of market liquidity imperils otherwise viable firms, but it shouldn't be in the business of bailing out specific, failing institutions. And yet, as several of our panelists explained, the Fed's subsequent rulemaking took a far looser view: as far as the central bank is concerned, a program is "broad-based" as long as more than one firm receives support, and a firm is insolvent only if it has already entered bankruptcy proceedings. In other words: the Fed can continue to do more-or-less as it pleases.
Why is this a problem? Enter Senators Warren and Vitter. As they both pointed out, the goal of their proposed legislation is not simply to tie the Fed's hands in a crisis. Rather, their overriding concern is that the very existence of these broad powers to bail out financial institutions encourages risk, leverage, and cavalier management in the banking industry, while simultaneously undermining any incentive lenders and investors have to supervise the financial firms into which they put their money. As Warren explained,
If you advertise to the market that the Fed is here, and no need for any large financial institution ever to have to go to the bankruptcy court house or declare itself insolvent, but instead there will be trillions of dollars available to back up these giant institutions, I think that changes fundamentally the behavior of the big banks themselves, the behavior of those who lend them money, the behavior of those who invest in them. And I've got to say, in all three cases: "not for the better," because it encourages riskier behavior knowing that there is an option available.
Warren and Vitter went on to point out that this whole dynamic distorts the market over time, tilting the playing field in favor of the biggest banks — for whom implicit government guarantees mean a lower cost of capital — and eroding the competitiveness of smaller financial institutions, who know they are not too big to fail. This leads, in Warren and Vitter's view, to greater market concentration and more systemic risk — the very things that financial regulation seeks to avoid.
Accordingly, the senators' proposed "Bailout Prevention Act" would significantly tighten the rules surrounding the Fed's 13(3) emergency lending, as amended by Dodd-Frank. First, it would define "broad-based" to mean that at least five firms must participate in any emergency lending program. Second, it would require that those participating firms certify that the value of their assets exceeds their liabilities. Third, it would insist that any emergency lending be offered at a penalty rate five percentage points above that on Treasury Bills. As Mark Calabria put it, "part of this should be making the Fed actually a lender of last resort, rather than a rescuer of first resort." It certainly seems like a good start — even if some of us would prefer that there was no lender of last resort at all.
The full discussion, which also touches on the best way to approach financial regulation going forward, is available below.
To receive invitations to future Cato events, please be sure to join the mailing list. You needn't miss out if you're not in Washington, DC, either: our public events are always streamed at cato.org/live.