If the Federal Reserve Board stretched the bounds of its emergency authority with the actions it took in 2008, Congress has found a way to snap things back into place.
The financial reform law put new limits on what the Fed can do under "unusual and exigent circumstances" and required that emergency measures be disclosed with a degree of transparency unheard of for the central bank.
The changes to Section 13(3) of the Federal Reserve Act are as much a warning to banks as they are a slap on the wrist for the Fed, which can no longer invoke it to take steps that would help a single company avoid bankruptcy or unload assets.
This means no more Fed backstops for companies that agree to rescue-style acquisitions, such as JPMorgan Chase & Co.'s purchase of Bear Stearns & Co., no more bailouts of reckless insurance companies a la American International Group Inc., and no more guarantees that the banks on the other side of trades with big, troubled firms will be made whole.
In theory, such measures will never be needed again thanks to another portion of the Dodd-Frank Act, which allows the government to seize and unwind distressed firms of systemic importance. In practice, the Fed's options for future crises will be narrower compared with the last one, regardless of how the resolution process pans out.
"I'm a bit worried that the Fed's hands will be unduly tied the next time an AIG-like problem arises — not that I'm an admirer of what we did with AIG," said Alan Blinder, the Princeton University economics professor and former Fed vice chairman.
The bailout of the insurance giant has been a sticking point even for supporters of the Fed's other emergency actions during the crisis, including interventions that stabilized the commercial paper and asset-backed securities markets.
In response, Congress, in the Dodd-Frank bill, instructed the Fed to limit future rescues to programs with "broad-based eligibility" and to establish policies to ensure that emergency loans are disbursed "for the purpose of providing liquidity to the financial system, and not to aid a failing financial company."
But the trouble with financial crises is that they frequently make it impossible to distinguish between issues of liquidity and issues of solvency — or between problems that are truly systemic and those that are concentrated in a few very large companies.
"Crises are centered in some mish-mash of institutions and markets," Blinder said. "Was the credit-default-swap part of the crisis a market problem or an AIG problem? I don't even know where to begin with that."
It is possible the Fed didn't either, but made its best guess, invoking 13(3) to take swift, bold steps to rescue the insurer from its costly misadventures in the derivatives market.
Those actions, while arguably helping to stabilize the financial system, triggered public reactions ranging from skeptical to outraged, particularly when it was disclosed that Goldman Sachs & Co. and other trading partners of AIG were paid in full for swap contracts with the bailed-out insurer.
The Fed has raised no objection to the new limits on its 13(3) authority. Chairman Ben Bernanke testified to Congress in February 2009 that "many of these actions might not have been necessary in the first place had there been in place a comprehensive resolution regime aimed at avoiding the disorderly failure of systemically critical financial institutions."
But in the absence of a resolution regime, the Fed took actions in 2008 that, combined with the shoot-from-the-hip atmosphere in which the Troubled Asset Relief Program was created, generated a strong constituency for constraints on the types of measures that can be taken in exigent circumstances.
"I believe the use of 13(3) and Tarp were probably necessary, and likely saved the financial system from a calamity that could have been worse than the Great Depression. But it was done very crudely," said Heath Tarbert, who helped negotiate Dodd-Frank as Republican special counsel to the Senate Banking Committee, before joining Weil, Gotschal & Manges LLP this year to run the law firm's financial regulatory reform working group. "I don't think there was necessarily the transparency that everyone would have liked."
Congress devoted several pages of Dodd-Frank to outlining standards of transparency for Fed actions taken in exigent circumstances.
Within seven days of authorizing an emergency loan or assistance facility, the Fed must submit to the House Financial Services Committee and Senate Banking Committee a special report justifying the exercise of 13(3) authority; identifying the recipients of the aid; detailing the date, amount, collateral requirements and other terms of the assistance and tallying the expected final cost to taxpayers. Then, every 30 days for the life of the loan, the Fed must give written updates regarding the value of the collateral, the interest and fees collected, and the ultimate cost to taxpayers.
The measure is as direct a response as possible to a laundry list of public concerns over the bailout of AIG. But in a nod to the customary discretion with which the Fed has traditionally acted, Dodd-Frank allows for the Fed chairman to request, in writing, that the committee chairmen and ranking members keep confidential the sections of the reports that specify the loans' recipients, size and collateral agreements.
Furthermore, Dodd-Frank gives the comptroller general the authority to "conduct audits, including on-site examinations," of the Fed, of banks within the Federal Reserve system and of specific credit facilities to assess the operational integrity or internal controls of an emergency program. Inspections also can be used to validate "the effectiveness of the security and collateral policies established for the facility," or to determine whether the program "inappropriately favors one or more specific participants over other institutions eligible to utilize the facility."
Dodd-Frank also says that the Fed "shall place on its home Internet website a link entitled 'Audit,' which shall link to a Web page that shall serve as a repository of information made available to the public" about its emergency measures, including audit reports by the comptroller general, annual financial statements prepared by an independent auditor and the reports required by the congressional banking and finance committees.
The law is not nearly as specific when it comes to instructing the Fed on how to build the emergency programs themselves.
Rather than dictating the kinds of collateral that the Fed may accept in exchange for special assistance, for example, the law merely directs the Fed to assign a "lendable value to all collateral" to make sure that the loan is "secured satisfactorily."
To Thomas Cooley, an economics professor at New York University's Stern School of Business, a lack of specific rules to protect the integrity of the Fed's balance sheet was a major omission. Paired with restrictions on the kinds of emergency action the Fed can take, he said, the alterations to 13(3) seem less palatable. "They've just constrained [the Fed] without having more sensible rules," he said. "It could come back to bite us in some future crisis."