In her final appearance before the Senate Banking Committee, former FDIC Chairman Sheila Bair confirmed that the Dodd-Frank Act would prevent bailouts along the lines we saw during the last financial crisis. This is the conventional view but, as the markets react to rumors of deteriorating economic conditions leading to the need for bailouts of Eurozone banks, and perhaps a contagion affecting U.S. banks, that confidence may be ill-placed.
History shows that Congress acted too aggressively in narrowing the Federal Reserve's authority to bail out entities in future crises and it may want to reconsider its actions.
The Federal Reserve found it difficult to bring stability to the economy during the last crisis. At a critical point, the board employed a rarely used authority, Section 13(3) of the Federal Reserve Act, to provide funds to finance nonbanks, including AIG. Experts continue to disagree on how much money was spent. The bailouts helped stabilize markets, but immediately led to criticism that the board had exceeded its authority. Some claimed it was for Congress, not a government agency, to allocate credit through government programs to certain favored sectors of the market.
In an approach that neatly fits a pattern familiar to historians of central banks but perhaps not policy makers, Congress agreed and limited the Fed's ability to use Section 13(3) to lend to corporations in future crises. Now, the board may make emergency loans only to "participants in any program or facility with broad-based eligibility" and must confer with the Treasury and Congress before lending to individuals.
The board must adopt a regulation to specify its policies, so that any emergency lending program provides liquidity to the financial system rather than bail out a failing company. The Fed must adopt these rules "as soon as is practicable," but more than a year after enactment, rules have not been proposed.
As unprecedented as the recent crisis may appear, students of history have seen the rough outlines of the same pattern occur repeatedly in the last 250 years.
A bubble appears, often due to low interest rates that arise when the government reduces its debt through a refinancing. Dissatisfaction with market returns on conventional assets leads to speculation in low quality assets. The bubble bursts. Credit evaporates.
In response, regardless of whether the central bank agrees or declines to provide liquidity, criticism results. In cases where the bank does act as a lender of last resort, it defends itself by pointing to profits gained in its stabilization efforts. A legislative inquiry follows, often with new rules limiting the central bank's ability to lend in future crises, but without success as the pattern inevitably repeats itself.
A good example of a crisis with similarities to our current circumstances is the Crisis of 1836-9. Also international in scope, that crisis followed a speculative boom. Before the creation of the Federal Reserve System in 1913, the Bank of England was the world's preeminent central bank and it responded to crises just as the Fed has done. Fearing a breakdown in credit, the Bank of England lent to a number of "crippled firms," some American, on personal and illiquid security and, since the term "moral hazard" was not yet coined, warning that these loans were not to serve as any kind of precedent.
Parliament reacted by forbidding a recurrence of the controversial bailout loans. The Bank of England had two functions at that time, to provide credit and to exercise monetary control. Remedial legislation, the Act of 1844, strictly separated the two functions and limited the Bank's ability to expand the money supply, which now would be tied to the level of gold reserves, with no exceptions, even in times of crisis.
The Act of 1844 may have been essential as a matter of political expediency, but it was doomed to failure. The surprise was that failure occurred so soon after enactment, leading the British government to quietly permit the Bank of England to break the law in response to crisis conditions. Market participants cared little, as long as credit was available when required.
A subsequent parliamentary inquiry confirmed that the Act of 1844 did not prevent overexcitement followed by a commercial crisis, did not discourage rash speculation, did not secure the market from violent fluctuations in the value of money, and did not lessen the severity of bankruptcies. Parliament stubbornly refused to amend the law, however.
Looking at the history of unsuccessful efforts to tame the economic cycle, one must ask whether Dodd-Frank will harm, rather than help the Fed's ability to react in the next crisis. When Congress prohibited future bailouts, it was reacting angrily, more to the fact that a crisis occurred than to the Fed's response. By limiting the options available to the board, especially by prolonging the time required to make a response, Congress surely is making the board's already demanding job all the more difficult.
We know that a crisis will recur. The board will have to react quickly, with the assistance of the Treasury, to create a "broad-based" program that critics still will perceive as favoring only a few market participants. Let us hope that the effort to restore confidence works and that Congress will subsequently resist the urge to tighten Section 13(3) further. Or, in a break from the cycle, Congress might consider restoring to the board its Section 13(3) authority before the next crisis erupts.
Donald N. Lamson is counsel in the financial institutions advisory and financial regulatory group of Shearman & Sterling LLP in Washington, DC. Prior to joining the firm, he spent more than 30 years at the Office of the Comptroller of the Currency.
