Risk & Compliance

Fed Changes Rule to Limit Emergency Lending

The final rule narrows the definition of "broad-based eligibility" to avoid bailouts of insolvent firms.
Katie Kuehner-HebertNovember 30, 2015

The U.S. Federal Reserve said Monday it had revised its rule on emergency lending to banks so the agency wouldn’t inadvertently favor certain big banks over others or bail out insolvent firms.

In response to criticism of an earlier rule the Fed drafted in 2013, the board clarified how it interpreted “broad-based eligibility” for an emergency loan. The rule adopted Monday defines “broad-based” to mean a loan that is not designed for the purpose of aiding failing firms and in which at least five entities would be eligible to participate.

The Fed said the clarification is consistent with the Dodd-Frank Act, which states that emergency loans should not be made to help companies avoid bankruptcy or resolution.

The final rule also broadens the definition of insolvency to cover borrowers who fail to pay undisputed debts as they become due during the 90 days prior to borrowing or who are determined by the board or lending Fed bank to be insolvent.

That change reflects criticism that the earlier rule was too narrow and had not included situations where a company has not yet entered formal bankruptcy or resolution proceedings, but may be insolvent from an accounting or other perspective.

Loans would come with a penalty rate and would have to be repaid in full on an accelerated basis if borrowers are found to have misrepresented their solvency.

“We have made significant changes to the proposed rule to ensure that our rule will be applied in a manner that aligns with the intent of the Congress and the Dodd-Frank Act,” Fed Chair Janet Yellen said in a news release.

During the last financial crisis, the Fed sent money to banks of all sizes, but also set up programs to target funds to a handful of major firms, according to the Wall Street Journal. Dodd-Frank called for the Fed to limit emergency lending to “broad-based” programs rather than to a select few institutions, excluding insolvent institutions from the loans and demanding enough collateral to protect taxpayers.

The final rule will take effect Jan. 1.

Financial Services Committee Chairman Jeb Hensarling, Texas Republican, issued a statement criticizing the rule, saying it still leaves the door open to bailouts.

Hensarling said the Fed Oversight Reform and Modernization Act of 2015, passed by the House of Representatives on November 19, would do a better job of preventing bailouts.

The bill “restricts emergency loans to financial institutions only and makes sure they are provided at a ‘penalty rate’ so banks are not improperly subsidized. [In addition,] the FORM Act injects greater accountability into the system by requiring not only a supermajority of Federal Reserve governors but also a supermajority of district bank presidents to approve any emergency loan,” said the statement by Hensarling.