Fed faces limits on crisis lending powers

The Federal Reserve's ability to give emergency loans to distressed institutions in a crisis would be restricted under legislation being prepared by lawmakers who want to stop "backdoor bailouts".

The proposed legislation - a striking challenge to the Fed from a bipartisan pair of senators - will reignite debate over whether the US succeeded in ending banks' "too big to fail" status with its response to the financial crisis.

The Fed contained panic during the crisis by offering emergency loans to institutions facing liquidity crunches. But after the meltdown Congress introduced restrictions to prevent the bailout of single struggling entities, while preserving Fed powers to provide liquidity to groups of firms.

It also gave regulators new powers to manage the orderly wind down of major financial institutions that are insolvent and threaten financial stability.

The new bill is rooted in concern among some lawmakers that the Fed is defying the law's intent. They say its proposed implementation plan would not curb its lending powers or eliminate the moral hazard created by the promise of government aid.

The bill is being drafted by an odd couple of US senators from opposing ends of the political spectrum: Elizabeth Warren, a liberal firebrand from Massachusetts, and David Vitter, a staunch conservative from Louisiana.

It could be introduced by the senators as early as Tuesday, according to people familiar with it.

It represents a worrying new threat for a central bank already under fire from some Republicans calling for reforms to improve its transparency.

The Fed is anxious to not have tighter fetters imposed on its emergency lending powers, which derive from section 13(3) of the Federal Reserve Act.

Donald Kohn, who served on the Fed's Board of Governors during the crisis and is now a senior fellow at the Brookings Institution, a think-tank, said: "I hope Congress keeps in mind why they founded the Fed in 1913 and allows the Fed to adapt its facilities to a 2015 world."

The post-crisis Dodd-Frank act amended the law with a compromise. It maintained the Fed's ability to act as a lender of last resort via "broad-based" liquidity programmes, but outlawed aid to individual insolvent companies.

The draft bill includes three key provisions, said the people familiar with it. One broadens the definition of "insolvency" used to exclude certain institutions, so that funds only go to those that are still fundamentally healthy.

A second strengthens the requirement that any lending facility is open to a "broad" swath of the market.

A third requires that Fed emergency loans are provided at a "penalty rate" of interest so that financial institutions do not get cheap capital. The bill's details could still change before it is introduced.

Jerome Powell, a Fed governor, said in February that "it would be a mistake to go further [than the Dodd-Frank amendments] and impose additional restrictions."

He added: "Because we cannot anticipate what may be needed in the future, the Congress should preserve the ability of the Fed to respond flexibly and nimbly to future emergencies."

The proposal is a long way from becoming law. Its chances of gaining traction on Capitol Hill depend on its sponsors winning over more moderate members of both parties, who are worried about neutering the Fed or upsetting the status quo.

In a joint statement last week, the Warren and Vitter offices said: "The two senators are . . . working on legislation to further halt megabank bailouts during a crisis." They declined to comment further.

Last August the two senators were among 15 lawmakers who wrote to Janet Yellen, the Fed chair, to register their objections to Fed's proposed rule implementing the revised lending law.

"The board's proposed rule places no meaningful restrictions on its emergency lending powers and, in a time of crisis, invites the same sort of backdoor bailout we witnessed five years ago," they wrote.

Marcus Stanley of Americans for Financial Reform, a group that wants tougher regulation of Wall Street, said: "People will try to portray this [bill] as something far out, but it's absolutely not. They're long-accepted principles that have traditionally governed lending of last resort and are well-supported by academic research."

Mr Kohn said the existing restrictions imposed by Dodd-Frank already constrain the central bank's ability to fulfil "legitimate lender of last resort functions."

For example, he said, its transparency requirements might deter potential borrowers from going to the Fed. In addition, he noted that in the middle of a crisis it was difficult to assess whether an institution was insolvent or merely illiquid.

He said: "One thing we learnt in 2007 and 2008 is you can have runs on the non-bank part of the financial sector that look a lot like bank runs, and I want the Fed to be able to do what it was founded to do in 1913, which is liquefy illiquid assets for solvent institutions that are suffering a loss of confidence because of fire sales and panics that threaten real economic activity."

The Fed has stressed that all of its emergency loans - which reached an aggregate outstanding balance of $1.5 trillion at their zenith - were repaid in full.

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