Cato Institute on the Federal Reserve ‘s Rescue Authority

Cato Institute

“Reforming the Federal Reserve’s Rescue Authority”

Wednesday, September 16, 2015 

Key Topics & Takeaways

  • Bailout Prevention Act: Calabria asked about the level of interest in S.1320 among Sen. Vitter’s (R-La.) colleagues in the Senate. Vitter pointed to what he called a “competition” between legitimate public concerns and the “powerful insider game” of financial institutions great influence in Congress. He said the bill’s progress would be a matter of whether the public debate can become significant enough to counter special interests. 
  • Glass-Steagall: Warren briefly discussed her proposal to reinstate the Glass-Steagall Act. She suggested that simplifying institutions would eliminate the need for many layers of “intrusive regulation” because the institutions Congress is most concerned with protecting, those with people’s savings accounts, would be far simpler.
  • Fed Emergency Lending: Stanley said the use of emergency lending powers during the crisis was “destructive and delayed necessary adjustments in the market,” but dismissed the idea that the debate should be simplified to the Fed having either its current powers or none at all. He said Section 1101 of Dodd-Frank, “in concept,” makes sense as long as solvency is addressed correctly. 

Speakers

Panel One: A Policy Perspective

Emergency Lending Powers

Moderator Ylan Mui of The Washington Post opened the discussion by asking about the Federal Reserve’s emergency lending authority and how it has changed since the crisis. Phillip Swagel of the University of Maryland explained that during the crisis, the Fed used its authority to support individual institutions, but that the law has changed since then. 

Marcus Stanley of Americans for Financial Reform called the Fed’s use of emergency lending powers during the crisis “absolutely unprecedented,” which led to the feeling that it had to be addressed in the Dodd-Frank Act through Section 1101. Dodd-Frank, he continued, required the Fed to only lend to solvent institutions as part of a broad-based program. However, he lamented that Section 1101, while good in principle, left two major loopholes that have been exploited by the Federal Reserve to maintain its discretion: 1) a “flimsy” definition of solvency that only requires that a firm not already be in a bankruptcy proceeding; and 2) the failure to define “broad-based.” 

Mui asked if the Federal Reserve should have emergency lending powers at all, to which the Cato Institute’s Mark Calabria answered that it should not. He argued for eliminating the Fed’s 13(3) powers because such lending is a mix of regulatory and monetary responsibilities that allows the Fed to “cover up regulatory failings” by tapping public money. He added that countries without lenders of last resort performed better during the Great Depression, and also suggested the lender of last resort powers in Japan have only kept insolvent banks alive and created “zombie institutions.” 

Stanley agreed that the use of emergency lending powers during the crisis was “destructive and delayed necessary adjustments in the market,” but dismissed the idea that the debate should be simplified to the Fed having either its current powers or none at all. He said Section 1101, “in concept,” makes sense as long as solvency is addressed correctly. 

Calabria said the evidence has shown him that having a lender of last resort changes the behavior of the banking industry by leading it to take more risks and become more highly-leveraged. 

Bailout Prevention Act

Swagel defended the use of emergency lending powers, and advocated that it should be maintained as long as the Federal Reserve can exercise good judgment in its use. He warned that S.1320, the Bailout Prevention Act, co-sponsored by Sens. Elizabeth Warren (D-Mass.) and David Vitter (R-La.) would cripple 13(3) by adding to the “reasonable restrictions” in Section 1101 of Dodd-Frank. He dismissed the legislation as nothing more than a “no big banks bill.” 

Stanley disagreed that the Warren-Vitter bill would cripple 13(3), and called it a sensible bill that “makes the principles of Dodd-Frank real and genuinely limits Fed discretion.” He dismissed concerns from Fed staff as a pushback from an institution that has worked with unlimited discretion for so long that any small change upsets them. 

FDIC Resolution Authority

An audience member asked whether concerns regarding the abuse of 13(3) should be mitigated now that the Federal Deposit Insurance Corporation (FDIC) has resolution authority under Title II of Dodd-Frank. Stanley agreed that Title II should lead to a “sea change” in how we look at emergency lending, and called it a form of emergency lending that requires resolution and liquidation of a failed institution, saying it is the right path forward. 

Panel Two: A Congressional Perspective

Bailout Prevention Act

Calabria next moderated a discussion with Sens. Elizabeth Warren (D-Mass.) and David Vitter (R-La.). He asked what a final rule from the Federal Reserve regarding its use of emergency lending powers should look like. Vitter began by pointing out that the fact he is working with a Democrat like Warren demonstrates how broad a concern too-big-to-fail (TBTF) is across the nation. He then explained that while the Federal Reserve is certainly capable of fixing its rule on its own, he doubted that it would because it has an interest in maintaining “maximum flexibility” for itself. For this reason, he stressed that legislation is needed. 

Warren stressed that the proposed legislation is about solving TBTF and addressing the Fed’s failure to propose a rule consistent with Congress’ intent in Dodd-Frank. She said Congress “quite reasonably” instructed the Fed to propose an effective rule and decried that the Fed had interpreted a “system-wide” problem to mean as few as two firms and “solvency” to simply mean that bankruptcy proceedings had not yet begun. She commented that the Fed might simply “set up a cart in front of a bankruptcy courthouse” and “intercept” firms before they climb the steps to file for bankruptcy. 

Calabria noted that the Fed has argued that it cannot easily make a determination of a firm’s solvency. Warren commented that “if that is a serious statement, then I am genuinely terrified.” She asserted that the Fed staff are the supervisors and regulators who are supposed to be “looking at books and assessing assets every day.” 

Vitter agreed that the Federal Reserve’s staff members “clearly have the ability to ascertain that.” He added the legislation is not intended to limit alternatives at a time of crisis, but to “do these things ahead of time to head-off a crisis.” 

Calabria asked about the level of interest in S.1320 among Warren’s and Vitter’s colleagues in the Senate. Vitter pointed to what he called a “competition” between legitimate public concerns and the “powerful insider game” of financial institutions great influence in Congress. He said the bill’s progress would be a matter of whether the public debate can become significant enough to counter special interests.  

Emergency Lending and Bank Behavior

Calabria stated his opinion that the expectation for an emergency lending facility changes the behaviors of banks. Warren agreed that this is “at the heart” of the problem, that the expectation of the Fed providing “trillions available to back up institutions,” fundamentally changes the behaviors of banks, creditors, and investors. 

Vitter agreed that the lending power “clearly encourages bad behavior” and shows that TBTF is “alive and well.” He stated he wants to “change this dynamic,” and so he is also working on a bill with Sen. Sherrod Brown (D-Ohio) to increase capital requirements for the largest banks. 

Other Proposals

Calabria asked if there are any other initiatives that Vitter and Warren are working on together. Vitter answered that he and Warren, along with other members of the Senate Banking Committee, “bounce ideas off each other all the time” and “have a whole suite of ideas.” 

Vitter commented that a major concern of his with the Dodd-Frank Act was that it is “completely dependent” on additional layers of regulations and new regulators, rather than using a more systemic approach that does not give people discretion. He pointed to his work with Sen. Brown on higher capital requirements as an example of a systemic fix that would take discretion away from regulators. 

Warren took this discussion of a systemic fix as an opportunity to discuss her proposal to reinstate Glass-Steagall. She suggested that simplifying institutions would cut the need for many layers of “intrusive regulation” because the institutions Congress is most concerned with protecting, those with people’s savings accounts, would be far simpler. She called for structural change to such complex institutions. 

Vitter commented that while he has not signed onto Warren’s proposal yet, he is interested in the idea and agreed that it would fit his desire for a more systemic approach to regulation. 

For more information on this event, please click here