Saturday, December 12, 2015

Did the Fed Really Curb its Emergency Lending Powers?

By Roy C. Smith

Last week the Federal Reserve announced that it would adopt restrictions imposed by Dodd Frank to limit its emergency lending powers under Section 13(3) of the Federal Reserve Act, but it now has even more room to act in the next crisis.

Section 13(3) provisions allow the Fed to lend funds to any entity outside the banking system if circumstances are deemed to be “urgent and exigent.”

In 2010, a Congress angered by federal “bailouts” of banks and other financial institutions passed the Dodd Frank Act, including in it an amendment to the Federal Reserve Act of 1913 to limit 13(3) programs that enabled loans to Bear Stearns and AIG during the financial crisis. The amendment requires such programs be limited to those with a “broad base” of eligibility (now interpreted to mean involving at least five different participants) that are also approved by the US Treasury Secretary.  The idea is to limit 13(3) to only being able to provide liquidity to multiple, solvent financial institutions in times of crisis.

It took the Fed five years to come up with these new rules to implement the amendment, despite its being spurred by Senator Elizabeth Warren, Representative David Vitter and others in Congress from both parties who seek to limit the Fed’s powers.

The Fed’s action, according to Congressman Vitter, “is the first real acknowledgment from the Fed that it needed to do more to curtail its own bailout authority.” 

The new rules will prevent the Fed from lending money to prop up a single failing firm, said Fed Chairman Janet Yellen. Both the Bear Stearns and AIG rescue operations were considered crucial to the 2008 effort to stabilize the financial system by both Ben Bernanke, then Fed Chairman, and Hank Paulson, Treasury Secretary at the time.

But a lot has changed since 2008 that makes the one-off emergency lending powers of Section 13(3) less important to maintaining stability.

First, there are no longer any potential too-big-to-fail financial institutions that are outside the orbit of regulatory control established by Dodd Frank for “systemically important” financial firms.

Of the five large, independent US investment banks existing in September 2008, only two have survived and both are now bank holding companies regulated by the Fed. And, four of the largest other US nonbank financial firms have been designated as systemically important by the Dodd Frank authorized Financial Stability Oversight Council, thus requiring them to be regulated by the Fed and subject to enhanced capital controls, intervention and other constraints that should reduce systemic risk, and thus the need for a future 13(3) loan.

Other large nonbanks (e.g., Fidelity, BlackRock, and some hedge fund groups) have successfully argued that as managers of other people’s money through hundreds of different investment vehicles, they should not be considered as a single entity whose failure would have systemic effects.  So far the Fed has bought (or has been forced by political pressures to buy) into these arguments, so presumably it would have no reason to assist them in a crisis.

So, the lost power to intervene in individual cases of systemic risk is now a power no longer needed. However, since September 2008, other powers available to the Fed to avert and manage crises have been greatly increased.

Dodd Frank conferred additional authority and influence on managing systemic risk to the Fed. It now conducts annual qualitative stress tests on large banks and can deny those who fail the ability to pay dividends or do other things. The Fed also sets capital adequacy levels, leverage limits, and the requirement for “total loss absorbing capital” (in which bond holders participate in losses). It monitors banks closely and has the power, and apparently the will, to force them to remain in safe waters.

The banks have complied with the Fed’s post-crisis requirements, so are safer. But this has meant that much of the financial risk the banks used to carry on their balance sheets has migrated into capital markets and the nonbank sector.

This sector is a multitude of nonsystematic firms that operate in financial markets, but it is not directly subject to Fed regulatory control.

But, don’t worry, the Fed has found important ways to assert de-facto control over the nonbanking sector too.

This is done through market intervention programs, in which the Fed, through asset purchases, can inject large amounts of capital to preserve market functionality and alleviate liquidity panics. After September 2008, the Fed began an unprecedented effort to stabilize financial markets across the board, ultimately expanding its balance sheet to $4 trillion from less than $1 trillion.

Indeed, as early as March 2008, after Bear Stearns was rescued by JP Morgan (with Fed assistance), the two-dozen or so authorized market makers in Treasury securities were struggling to maintain their funding arrangements. As a result, the Fed established a temporary Primary Dealers Credit Facility and Term Securities Lending Facility to assist them. This was the first time in the history of the Fed that it had provided funding for nonbank broker-dealers in its efforts to maintain market stability.

These programs usually are ended after stability returns, but the Fed seems comfortable in starting them up whenever they seem to be needed.

Today, as a result of capital and other constraints, many banks have reduced their exposure to the repo markets, and nonbank money market funds and other participants have increased theirs. Consequently, in 2013 the Fed offered a $300 billion Reverse Repo Facility to assist dealers in this important market.

If a problem in the nonbank sector should require it, the Fed can intervene more precisely by declaring a 13(3) lending condition after designating five or more intended recipients in order to stabilize their broad based ability to roll over maturing liabilities of their own or of funds they manage. This would be within the scope of the new rules, even if only one firm (targeted for assistance) actually used the facility.

Though there are many in Congress who would like to clip the wings of the Fed further, the Fed is more powerful than ever. "We're perfectly happy now that there are alternative ways to deal with a failing firm,” said Ben Bernanke recently, “the Fed doesn't have to intervene in [individual cases] the way we did in 2008."

And, he might have added, what we have learned from our various intervention efforts has increased our confidence that when another crisis comes we will have the tools needed to meet it.

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