Academic journal article Federal Reserve Bank of St. Louis Review

Federal Reserve Lending to Banks That Failed: Implications for the Bank Insurance Fund

Academic journal article Federal Reserve Bank of St. Louis Review

Federal Reserve Lending to Banks That Failed: Implications for the Bank Insurance Fund

Article excerpt

DEBATE THAT LED TO PASSAGE of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 focused on changes in public policy to reduce losses of the deposit insurance funds. One aspect of public policy subject to such scrutiny was lending by the Federal Reserve to troubled banks. A report prepared by congressional staff indicated that over 300 of the banks that failed in 1985-91 were borrowing from the Fed when they failed, and that 90 percent of the banks that borrowed for extended periods of time eventually failed.(2) Other evidence caused the authors of that congressional staff report to conclude that Fed credit extended the life of borrowers that ultimately failed. Critics of Fed lending practices concluded on the basis of this evidence that lending to troubled banks increased losses to the Bank Insurance Fund (BIF).(3) This concern led to constraints on Federal Reserve lending to troubled banks in FDICIA.

Restrictions on Federal Reserve lending to troubled banks raise several issues, including the proper role of the discount window and the necessary freedom of action for a central bank in limiting systemic impacts of problems in the operation of a banking system. Failures of banks may have systemic impacts if they cause other banks to fail or cause disruptions in the payment system or financial markets. This article focuses on the more narrow issue of whether Federal Reserve lending to troubled banks in recent years raised the losses of BIF. Critics of Fed lending practices have emphasized anecdotal evidence from a few bank failure cases, particularly the failures of the Bank of New England and the Madison National Bank.(4) This article, in contrast, examines whether the record of Fed lending to many failed banks supports the arguments of the critics.

The evidence in this study indicates that loans from the Fed to many of the failed banks in their last year were concentrated near the time of failure and were allocated to the banks with the greatest liquidity needs. The evidence does not support the argument that Federal Reserve lending to troubled banks increased the losses of the FDIC.

FEDERAL RESERVE POLICY ON LENDING TO TROUBLED BANKS PRIOR TO FDICIA

Prior to passage of FDICIA in 1991, the Federal Reserve had a long-standing policy of not lending to nonviable institutions, except when such lending would facilitate an orderly resolution of institutions. Lending to facilitate orderly resolutions had been undertaken in cooperation with the institutions' supervisors and with the deposit insurance authorities. Under this policy, the Federal Reserve loaned to some troubled banks for extended periods of time. Two of the large banks that received Fed credit for extended periods of time were the Franklin National Bank, in 1974, and the Continental Illinois National Bank, in 1984.(5)

In response to public criticism that the Federal Reserve had subsidized the Franklin National Bank, the Fed amended its lending regulations to establish a new, higher special discount rate for protracted emergency assistance to particular banks. Figure 1 indicates that such emergency assistance--which has been called extended credit since 1980--at times has been the predominant form of discount window lending. Prior to passage of FDICIA late in 1991, there were no legal constraints on the size or duration of Federal Reserve lending to troubled banks.

THE DEBATE OVER LENDING TO TROUBLED BANKS

The Issues

Public discussion that led to passage of limits in FDICIA on the authority of the Federal Reserve to lend to troubled banks involved two issues. The first issue, philosophical in nature, involved the proper purpose for lending. Walker Todd (1988, 1991, 1992), a major contributor to this debate, has asserted that the proper role for the discount window is to lend for short periods of time to solvent banks that are temporarily illiquid. Todd has described Federal Reserve lending to troubled banks for extended periods of time as the substitution of credit from the Federal Reserve for capital of the banks, which he considered inappropriate use of the discount window. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.