By limiting the Federal Reserve's ability to lend via the discount window, the banking reform law has poked a hole in the proverbial safety net.
The new law limits how long a district Federal Reserve bank can issue extended credit to a bank.
It also makes the Fed liable for some costs of expensive resolutions at banks that had borrowed from the discount window while ailing.
In effect, the bill makes it harder for the central bank to prop up troubled institutions while they work out credit problems. The restrictions are designed to make banks more conscientious about avoiding high-risk lending that could erode asset quality.
"It forces all bankers to raise their prudence yet another notch," said Neil Soss, chief economist at First Boston Corp. If you are a banker, he said, "your ability to rely on the safety net is reduced."
A Less Flexible Fed
But the provision also limits the Fed's flexibility in dealing with troubled banks - a change that some experts find ominous.
No Federal Reserve bank can lend to a single bank for more than 60 days out of any 120, unless top regulators or the Federal Reserve chairman certify that such lending is appropriate.
In addition, the Federal Reserve will have to pay for any loss the Bank Insurance Fund incurs as a result of discount window lending - that is, any losses beyond what resolution would have cost if the Fed's lending had not sustained the bank so long.
Weeks, Not Months
These changes still allow the Fed to lend to troubled banks. An institution with appropriate collateral can borrow from the central bank for several weeks, just as before.
But a Federal Reserve bank is no longer able to sustain banks for months without specific authorization.
The bank unit of Southeast Banking Corp., for example, had reportedly obtained extended credit from the Federal Reserve Bank of Atlanta for nearly two months before its principal assets were sold to First Union Corp.
At one point, Southeast's borrowings from the Fed neared $500 million. If Southeast were failing today, it would have a harder time obtaining such liquidity support.
By making it harder for banks to survive on liquidity lifelines from the Fed, the bill tries to hasten the cleanup that the industry needs.
High Cost of Delay
"The overall cost of [some] failures could have been mitigated if the Fed hand't put a BandAid on a cancer, so to speak," said Jan Hurley, a senior market analyst at Chase Manhattan Corp.
Still, some experts worry that the new limits on the Fed's discretionary ability to lend could cause problems down the road.
"It certainly sounds like it's chipping away at some of the Fed's independent," said Stephen Gallagher, a money market economist at Kidder, Peabody & Co.
Politically Influenced Aid
Political considerations could start to influence which banks are allowed to obtain long-term Fed loans, according to David Jones, chief economist at Aubrey G. Lanston.
That's because regulators, not just central bank officials, would be able to vote on whether to extend loans to troubled banks for more than 60 days.
Discount window lending "becomes a force through which credit can be directed to certain parts of the economy," said Mr. Jones. "If regulators and Congress get into this business, they're going to have all sorts of vested interests."
In addition to changing the rules for extended borrowing from the discount window, the banking reform law makes it possible for securities firms to borrow from the window in extreme circumstances - for example, in a period of extreme market stress such as occurred in October 1987.
Such borrowing becomes possible only if five Fed governors vote to support the lending and if the securities firm has adequate collateral.