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Financial Reform and the Fed's Bailout Capability

June 17, 2010 - by Hilary Worden

Included among the financial reforms that may soon become law is an attempt to restrict the Fed’s ability to bail out failing companies by changing a small but important paragraph in the Federal Reserve Act: section 13.3. 13.3 gives the Federal Reserve significant latitude in making emergency loans and is, for instance, what made possible the $29 billion loan to JPMorgan Chase in 2008. The financial reform bills passed by the House and Senate both include a number of additions and modifications to the paragraph, and whatever bill is eventually signed would likely significantly reduce the freedom of the Board to make such loans.

Currently, the Federal Reserve Act allows these emergency loans provided three conditions are met:

  • There are “unusual and exigent circumstances”
  • The borrower is not able to secure enough credit from other sources
  • There has been an affirmative vote of at least five members of the Board of Governors

The financial reform bills would add many new conditions and restrictions. Significantly, both bills prohibit assistance for a single, specific entity. The Senate bill states that loans must be made “for the purpose of providing liquidity to the financial system, and not to aid a failing financial company,” and changes the language of the section so that assistance must come through a “program or facility with broad-based eligibility” (rather than going directly to a specific company). Similarly, the House bill states that the Federal Reserve can authorize loans “only as part of a broadly available credit or other facility and may not authorize [loans] for only a single and specific individual, partnership, or corporation.” Apart from this commonality, however, the House and Senate bills are quite different in their handling of 13.3.

The House bill goes a long way in distributing power away from the Board of Governors. Instead of allowing unilateral action by the Board, the House bill requires that:

  • At least six of the nine members of the new Financial Stability Oversight Council agree that “a liquidity event exists that could destabilize the financial system;”
  • The Secretary of the Treasury has consented;
  • The President has certified that an emergency exists; and
  • Congress has not adopted a joint resolution of disapproval.

The Senate bill lacks such an extensive set of new restrictions, but does require the Secretary of the Treasury’s approval for the creation of any new program or facility for emergency lending.

Additionally, though both bills have a couple provisions to protect taxpayers from losses, they have none in common. The House bill limits the funds available to $4 trillion, requires there to be at least a 99% chance that a loan will be repaid, and prohibits low quality assets from being used as security. The Senate bill, on the other hand, requires sufficient collateral for emergency loans to protect taxpayers, and prohibits insolvent borrowers.

On the crucial issue of keeping the public informed, the bills again vary. Under the Senate bill, within a week of a loan being made, the Board would have to make a report including (among other things): a justification for the loan; the identity of the recipient; how much the loan was; requirements imposed (such as rules for employee compensation); and the expected cost to taxpayers. An update would have to be made every 30 days. However, at the request of the Chairman of the Board, the information could be kept confidential. The Senate bill also allows the Comptroller General to review any lending programs, but requires that identifying details be kept confidential until the Board of Governors releases the information or until a year after the program ends.

The House version requires that the Financial Stability Oversight Council notify the House and Senate if it determines that there are liquidity events that threaten the stability of the financial system. It also requires that, within two years, the Comptroller General conduct an audit of the Board’s use of the power granted under 13.3 in dealing with the current financial situation. A report would be submitted to Congress and made available to the public within 90 days of the audit’s completion. The Senate bill also requires the retroactive audit of loans made under 13.3 from December 1, 2007 to the date of the passage of the final bill.

The Congressional negotiators clearly have their work cut out for them on the matter of 13.3, but any product of the current House and Senate bills will almost surely radically reduce the Fed’s ability to make emergency loans at will.

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