New Fed Rule Limits “Too Big To Fail” Bailouts

New Fed Rule Limits “Too Big To Fail” Bailouts

Under pressure from Congress, the Fed says no more too big to fail bailouts.

In a press release Monday, the U.S. Federal Reserve approved the final version of a new rule that limits the ability of the central bank to loan money to financial institutions in an effort to appease lawmakers who are concerned about the Fed’s nearly unlimited authority to print money to add to the financial system.

This new rule banning bailouts of too big to fail banks has been a long time coming, as it was mandated by the 2010 Dodd-Frank law, which called for limitations on the emergency lending powers of the central bank. A number of conservative lawmakers have expressed concerns about the relatively few restrictions on the Fed’s operations as it decided to spend taxpayer dollars to keep firms afloat during the 2008 financial crisis.

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Of note, the Fed published a draft version of the new rule in 2013, but that version met a frosty reception in Congress as many said it still left way too much latitude for the Fed.

The final Fed rule is scheduled to be implemented on January 1, 2016.

Statement from Fed Chair Yellen

“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,” noted Federal Reserve Chair Janet L. Yellen in her comments Monday on the release of the final version of the new rule.

More on new Fed rule limiting “Too Big To Fail” bailouts

The Dodd-Frank Act passed five years ago requires the Fed to set rules specifically prohibiting most emergency lending to insolvent borrowers. The PR from the Fed noted that the final rule notably broadens the definition of insolvency to include borrowers who fail to pay undisputed debts in the 90 days prior to borrowing or who are determined by the Fed to be insolvent. The Fed statement bots that they decided on a broad definition of insolvency including situations where a firm is not yet formally bankrupt, but is clearly  insolvent from an accounting perspective.

Of particular interest, the final rule does include the requirement mentioned in the Dodd-Frank Act that all lending under programs during periods of crisis must also be approved by the Secretary of the Treasury. Moreover, the Federal Reserve must still determine that “unusual and exigent circumstances” before moving ahead with authorizing emergency credit programs.

Finally, the PR noted that the Fed’s practice in extending emergency credit of setting the interest rate for all loans at a “penalty rate” so as to encourage borrowers to repay emergency credit as quickly as possible. The new Fed rule has been changed from the original proposal to incorporate this practice by requiring the interest rate for credit extended under the lending programs to be set at a level that is above the market rate, affords liquidity in unusual and/or difficult circumstances, but that will encourage repayment and discourage use of the program once the financial crisis situation begins to return to normal.

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