WASHINGTON — The Federal Reserve Board unanimously approved a final rule Monday implementing changes to its emergency lending authority that includes significant concessions to critics of the original proposal.

The Dodd-Frank Act imposed new restrictions on the Fed's ability to provide emergency support, which had previously been mandated under Section 13(3) of the Federal Reserve Act. Dodd-Frank requires such emergency actions to be limited to benefiting broad-based market sectors rather than individual firms. But critics, including some lawmakers, argued the 2013 proposal could allow the central bank to work around the restrictions and still aid specific companies. Observers complained in their comments the Fed's proposed definition of a "broad-based" facility could potentially be interpreted as containing as few as two firms.

To address this issue, the final rule specifically defines "broad-based" as containing at least five institutions, and, according to Fed staff, the rule is written in a way to make eligibility as inclusive as possible. The final rule also says that a facility may not be created to aid "one or more" specific companies in avoiding bankruptcy.

The Dodd-Frank requirements are "a critical tool for responding to broad and unusual market stresses," Fed Chair Janet Yellen said at an open meeting of the Fed board. The changes in the final regulation, she added, will "ensure that our rule will be applied in a manner that aligns with the intent of Congress."

The intent of the 2010 statutory changes was to eliminate the Fed's ability to directly keep a failing firm afloat, as was the case with American International Group. Instead, the Fed could only lend to a "broad-based" set of eligible firms in a certain market and failing firms could not qualify as eligible.

Fed Gov. Daniel Tarullo, who heads the central bank's supervisory committee, said the final rule achieves a balance between not encouraging bad behavior via bailouts and the need for regulators to still do something in crises to avoid a system collapse. That balance is also achieved, he said, in Dodd-Frank provisions to create a new Federal Deposit Insurance Corp. resolution facility — through Title II of the law — and require firms to submit plans on how they could be resolved without broader repercussions.

"We have a longstanding tension between the policy aims of containing moral hazard through ex ante constraints on how we provide liquidity to the market with wanting to retain flexibility to provide such liquidity as may be needed to combat unanticipated sources of serious financial stress," Tarullo said. "Congress, in changing 13(3), didn't just change 13(3) — it also created Title II and required us to do resolution planning, and I think we need to look at those … pieces as a package. This proposed final rule does a much better job of balancing the tradeoffs between the ex ante moral hazard constraining policy aim and the ex post desire to be able to provide liquidity to the financial system."

The Fed had also received criticism of how the draft proposal defined of "insolvent" with respect to what firms would be barred from inclusion in a facility. The proposed rule relied on a formal definition of insolvency as having entered into bankruptcy proceedings or some other form of legal resolution. But commentators said that definition was too narrow and would not have applied to virtually any of the stressed firms that received bailouts during the 2008 crisis.

The final rule redefined "insolvent" as a firm that has been unable to pay its obligations in the preceding 90 days or where the Fed board or supervisory Federal Reserve Bank has determined that the institution is insolvent. The rule further prohibits recipients of emergency loans from using those funds to lend to another entity to stave off bankruptcy and bars entities in conservatorship from eligibility.

The changes to the rules address some of the biggest concerns voiced by Sens. Elizabeth Warren, D-Mass., and David Vitter, R-La., who drafted a bill in May that would have specifically defined a 13(3) facility as containing five entities and would have required supervisors to certify that any recipient firm is solvent.

Both Warren and Vitter said in statements that the Fed's amended rules were a vast improvement over the draft proposals, but each had reservations about whether they had prohibited bailouts completely. Warren said that the Fed's rules "incorporated many ideas" from the Warren-Vitter Bill but pointed out that there are "still loopholes that the Fed could exploit to provide another back-door bailout" to failing banks. Vitter likewise said that the new rules are "the first real acknowledgement from the Fed that it needed to do more to curtail its own bailout authority," but said that "more needs to be done" to prevent new taxpayer-funded bailouts.

Karen Shaw Petrou, managing partner of Federal Financial Analytics, said there is no mistaking the political influence that the Warren-Vitter bill had on the Fed's decision to make concessions."The Fed saw the political handwriting on the wall because it's now up there in neon," Petrou said. "The FRB is fighting a last-ditch battle to save its monetary-policy powers and thus decided to concede on emergency lending."

Both Warren and Vitter said in statements that the Fed's amended rules were a vast improvement over the draft proposals, but each had reservations about whether they had prohibited bailouts completely. Warren said that the Fed's rules "incorporated many ideas" from the Warren-Vitter Bill but pointed out that there are "still loopholes that the Fed could exploit to provide another back-door bailout" to failing banks. Vitter likewise said that the new rules are "the first real acknowledgement from the Fed that it needed to do more to curtail its own bailout authority," but said that "more needs to be done" to prevent new taxpayer-funded bailouts.

 

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