Federal Reserve Chairman Ben S. Bernanke and fellow U.S. policymakers may find themselves hampered in restoring financial stability should the European debt crisis spread to America.
The Dodd-Frank legislation passed last year prohibits the Fed from engaging in rescues of individual financial firms, such as it did with Bear Stearns Cos. and American International Group Inc. during the 2008 financial crisis. Lawmakers also banned the Treasury Department from again using an emergency reserve program to backstop money market funds. And the Federal Deposit Insurance Corp. now has to get congressional approval before it can guarantee senior debt issued by banks.
Investors "don't realize the extent to which Congress has tied people's hands," said Donald Kohn, who served as vice chairman of the Fed from 2006 to 2010 and is now senior economic strategist for Potomac Research Group in Washington, an independent research firm. "There is less room to maneuver for the authorities."
In passing Dodd-Frank, lawmakers sought to end government bailouts of financial institutions deemed to be "too big to fail." They beefed up regulation of the industry, required banks to hold more capital and sought to discourage excessive risk-taking by curbing the ability of the federal government to rescue them from their mistakes.
The danger is that the legislation may have gone too far in limiting the leeway of the central bank and other policymakers to act in a financial meltdown, Kohn said. The result: While crises may be less frequent than before, they may be harder to contain once they occur.
"If you have a number of contagion problems all at once and are having liquidity problems, I worry that there isn't enough play in the joints" to handle that, said John Dugan, a former comptroller of the currency who is now a partner with Covington & Burling LLP in Washington.
The biggest risk for now is that Europe's sovereign debt troubles undermine the U.S. banking and financial system. The U.S. would not be able to "escape the consequences of a blowup in Europe," Bernanke said on Nov. 10. "The world's financial markets are highly interconnected."
U.S. stock prices have dropped this month, largely driven by concerns about the turmoil in Europe. Some banks are trading at their lowest levels since early 2009.
U.S. banks have about $169.7 billion in loans to Greece, Ireland, Portugal, Spain and Italy, equivalent to about 12.5% of their capital, according to calculations on Oct. 25 by David Hensley, director of global economics for JPMorgan Chase & Co. in New York.
"If this is just a 50% default by Greece, I don't worry about the American banking system," said Alan Blinder, a former vice chairman at the central bank who is now a professor of economics at Princeton University in New Jersey. "If this is a 50% default by Italy, Spain, and, and, and, I worry about the whole world's banking system."
An economic calamity in Europe "is not something that we would be insulated from, although the Fed would obviously do all we could to maintain stability and to keep monetary policy easy and do whatever is necessary to try to minimize the damage," Bernanke said at a town hall event in El Paso, Texas.
The central bank's ability to provide liquidity to the financial system though will be limited by the Dodd-Frank Act, according to John Williams, the president of the Federal Reserve Bank of San Francisco. "Some of the tools that were deployed in 2008 and 2009 to stem a full-blown meltdown of the financial system may not be available in future crises," he said in a speech on Nov. 11 in Washington.
The Fed can still lend money to banks via its discount window. And it can inject liquidity into the money market by buying U.S. Treasury and federal agency securities from primary dealers. What was circumscribed by Congress was the Fed's emergency lending authority under section 13(3) of the Federal Reserve Act.
While the Fed is prohibited from bailing out individual firms under Dodd-Frank, it can use its 13(3) powers to provide "broad-based" liquidity to the financial system, as long as it gets the approval of the Treasury Secretary first, something Blinder said would not be difficult during a crisis. "You can bail out a market like commercial paper," he said. "You can't bail out a bank."
Policymakers have one big advantage they didn't have in 2008-9, according to Blinder. They won't have to invent a host of new emergency lending facilities. They can use some of the ones they employed just a couple of years ago.
Citing "unusual and exigent circumstances," the Fed set up six facilities to inject liquidity into the financial system in the last crisis. They included programs to promote the purchase of commercial paper and to help finance primary dealers that the Fed uses in its operations in the money market. The facilities provided $600 billion to the financial system at their combined peak in November 2008, according to 2010 report by the Fed's inspector general.
One complication under the new law: The central bank has to tell selected lawmakers which financial firms are benefiting from its assistance within seven days of authorizing an emergency facility. It then has to file updates every 30 days to the House Financial Services Committee and the Senate Banking Committee.
Kohn said that may make firms wary of drawing on the Fed's help out of fear that they will be tagged as being in trouble.
"If I were a potential borrower, I would stay away from the Fed unless I absolutely had to go," said Kohn, who now also serves on the interim financial policy committee of the Bank of England. "It might be harder for the Federal Reserve to get liquidity into the system."
