Last week, I had the pleasure of hearing Senator Elizabeth Warren speak at a dinner in Washington DC. In her speech, she outlined proposals to limit the Federal Reserve’s ability to provide emergency lending in a crisis. I listened with growing concern. Surely Senator Warren cannot seriously be suggesting that Congress should constrain the Fed’s ability to do whatever it takes to prevent collapse of the financial system? As we know from Lehman Brothers, it only takes one failure of a systemically-important bank to cause a catastrophe.
It seems that she is indeed proposing exactly that. In August 2014, Senator Warren and other Senators sent a joint letter to Chairman Janet Yellen of the Federal Reserve recommending a number of changes to the Federal Reserve’s interpretation of Section 1101 of the Dodd-Frank Act. This was not the first attempt to tighten the Fed’s interpretation: in January 2014 a similar letter was sent to Chairman Bernanke by the chairman of the Committee on Financial Services of the House of Representatives.
But Senator Warren has now gone further. In collaboration with Senator David Vitter, she has created a draft bill which would force the Federal Reserve to restrict emergency lending, even in a systemic crisis.
Section 1101 of the Dodd-Frank Act amends Section 13 of the Federal Reserve Act to limit the Fed’s ability to support distressed banks and make it accountable to Congress for its emergency lending decisions. It restricts Fed emergency lending to “participants in programs and facilities with broad-based eligibility” and adds the following specific requirements:
(i) The Board shall establish…..policies and procedures governing emergency lending….Such policies and procedures shall be designed to ensure that any lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses, and that any such program is terminated in a timely and orderly fashion.
(ii) The Board shall establish procedures to prohibit borrowing from programs and facilities by borrowers that are insolvent…..A borrower shall be considered insolvent for the purposes of this sub-paragraph if the borrower is in bankruptcy, resolution under title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act, or any other Federal or State insolvency proceeding.
(iii) A program or facility that is structured to remove assets from the balance sheet of a single and specific company…..shall not be considered a program or facility with broad-based eligibility.
(iv) The Board may not establish any program or facility….without the prior approval of the Secretary of the Treasury.
The purpose of these provisions is to prevent the Fed bailing out individual banks, not to limit its ability to prevent financial system meltdown. But as I shall explain, these two objectives are indistinguishable in a crisis.
“Bagehot’s Dictum”, named after the 19th-century British journalist Walter Bagehot, is cited by Senator Warren and others in their letter to Chairman Yellen as the foundation of good lender-of-last-resort practice, though they incorrectly attribute it to Dr. Allan Meltzer:
As Dr. Allan Meltzer testified before the Senate Banking Committee, a true lender-of-last-resort policy – permitting emergency lending on “good collateral” at a penalty rate during financial turmoil – would create market discipline because banks that lack good collateral would be allowed to fail without disrupting the economy.
The Senators argue that the Fed’s interpretation of Section 1101 does not conform to Bagehot’s Dictum and therefore does not achieve the intended market discipline. They therefore propose the following changes:
- Establish a clear time limit for a financial institution’s reliance on the Board’s emergency lending and provide a concrete limit on the duration of each lending facility or program;
- Establish procedures for the orderly unwinding of any emergency lending program or facility, including how the Board will cover any associated losses;
- Adopt a broader definition of “insolvent” to include banks that WOULD BE insolvent without Fed emergency lending;
- Expand the definition of “broad-based” to exclude lending to specific sections of the financial system such as repo or commercial paper markets
- Establish limits and a “penalty rate” on lending terms. The aim appears to be to force the Fed’s emergency lending to be at or near prevailing market rates.
I have to say that I think all except the second of these is barking mad. They display a lamentable lack of understanding of how financial crises proceed.
In a financial crisis, Bagehot’s Dictum does not work. Asset prices fall rapidly, rendering insolvent institutions with trading books that must be marked to market. Consequently, market participants are unable to decide who is solvent and who is not. They become unwilling to lend to each other: short-term lending markets such as repo and commercial paper freeze and market rates rise exponentially. This is what happened when the fall of Lehman Brothers bankrupted AIG and forced Reserve Primary MMF to “break the buck”.
In such a situation, it is not possible for the Federal Reserve to determine whether or not a bank is solvent, and it is very unwise for it to attempt to do so. Firstly, asset values change very rapidly and may bear little relationship to fundamentals. On what basis is the Fed supposed to value assets and liabilities? Secondly, a bank whose asset value is collapsing rapidly and which is unable to fund itself because of a market freeze and sky-high interest rates will fail very fast indeed if the Fed wastes time trying to decide whether or not it is insolvent. Insolvency could even be caused by the Fed delaying emergency support. A liquidity crisis for a bank becomes a solvency crisis if not treated quickly, even if the bank was healthy beforehand.
It is also impossible for a “penalty rate” to be anywhere near market rates in such a crisis. Warren complains that emergency lending to banks in the 2008 crisis was at rates well below market rates. Yes, absolutely it was. After Lehman, market rates headed for the moon. They were not remotely affordable and had nothing to do with fundamentals in borrowing institutions. Lending at below market rates was essential if banks were to remain solvent.
Nor does the Fed have any idea how long a crisis will last, or how long it will take for banks to be in a position to repay the lending. That depends on the economic fallout. If the consequence of the crisis is a deep recession and a deleveraging cycle such as we saw from 2009 onwards, it can take a long time for banks to return to health. Setting an arbitrary time limit after which they must repay the lending regardless of their financial position may cause further distress, prolong the economic recession and impede lending to households and businesses. It may even trigger another crisis.
But Senator Warren’s worst proposal is her suggestion that the Fed should be prevented from providing liquidity support to short-term lending markets such as repo and commercial paper. This is batshit insane. The short-term lending markets are the lifeblood of the financial system. When they freeze, so do essential functions such as payments. The economic consequences don’t bear thinking about. Financial flows MUST be preserved in a crisis, even if that means supporting interbank lending markets, both secured and unsecured.
Senator Warren’s desire to tighten the Fed’s interpretation of the Section 1101 provisions is driven by her laudable ambition to force banks to behave responsibly and thus limit risks to the taxpayer. But these proposals run the terrible risk of making it impossible for the Fed to support the financial system in a crisis. By all means introduce measures to prevent crises happening in the first place: force banks to have bigger capital and liquidity buffers, maintain good underwriting standards, pay traders less, treat customers better. But don’t, PLEASE don’t interfere with Fed crisis management.
These proposals must be rejected.
