Dodd-Frank Limits Fed's Flexibility in a Crisis

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.

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