Academic journal article Federal Reserve Bank of St. Louis Review

Federal Reserve Lending to Troubled Banks during the Financial Crisis, 2007-2010

Academic journal article Federal Reserve Bank of St. Louis Review

Federal Reserve Lending to Troubled Banks during the Financial Crisis, 2007-2010

Article excerpt

Numerous commentaries have questioned both the legality and appropriateness of Federal Reserve lending to banks during the recent financial crisis. This article addresses two questions motivated by such commentary: Did the Federal Reserve violate either the letter or spirit of the law by lending to undercapitalized banks? Did Federal Reserve credit constitute a large fraction of the deposit liabilities of failed banks during their last year before failure? The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) imposed limits on the number of days that the Federal Reserve may lend to undercapitalized or critically undercapitalized depository institutions. The authors find no evidence that the Federal Reserve ever exceeded statutory limits during the recent financial crisis, recession, and recovery. In most cases, the number of days that Federal Reserve credit was extended to an undercapitalized or critically undercapitalized depository institution was appreciably less than the number of days permitted under law. Furthermore, compared with patterns of Fed lending during 1985-90, the authors find that few banks that failed during 2008-10 borrowed from the Fed during their last year prior to failure, and even fewer had outstanding Fed loans when they failed. Moreover, Federal Reserve loans averaged less than 1 percent of total deposit liabilities among nearly all banks that did borrow from the Fed during their last year. It is impossible to know whether the enactment of FDICIA explains differences in Federal Reserve lending practices during 2007-10 and the previous period of financial distress in the 1980s. However, it does seem clear that Federal Reserve lending to depository institutions during the recent episode was consistent with the congressional intent of this legislation. (JEL E58, GO 1, G21, G28)

Federal Reserve Bank of St. Louis Review, May/June 2012, 94(3), pp. 221-42.

The Federal Reserve responded aggressively--some argue too aggressively--to the crisis that enveloped the world financial system in 2008-09. Using powers granted by legislation enacted during the Great Depression, the Fed established several special lending facilities to (i) provide liquidity to the commercial paper market, money market mutual funds, and investment banks and (ii) facilitate orderly resolution of two large troubled financial firms (Bear Stearns and Co. and American International Group). In addition to providing billions of dollars through these facilities, the Fed also lent billions to depository institutions (commercial banks, savings institutions, and credit unions) through its long-standing discount window programs and a Term Auction Facility (TAF) established in December 2007. (1) The Fed's aggressive response to the crisis has been heavily criticized, though the Fed's defenders contend that it was necessary and successful in helping the economy weather the worst financial crisis since the Great Depression. (2)

This paper examines the Fed's lending to depository institutions (hereafter "banks") during the recent financial crisis, recession, and recovery. Some observers contend that the Fed lent inappropriately to weak or insolvent banks, or that its lending may have merely delayed the inevitable failures of many banks and perhaps increased losses to the Federal Deposit Insurance Corporation (FDIC) Deposit Insurance Fund. (3) The Federal Reserve Act specifies the terms under which the Fed is permitted to lend to banks. Section 142 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) limits--but does not prohibit--Federal Reserve lending to undercapitalized or critically undercapitalized banks. With certain exceptions, FDICIA prohibits the Federal Reserve from lending to (i) any undercapitalized depository institution for more than 60 days in any 120-day period and (ii) any critically undercapitalized institution beyond the fifth day after the institution becomes critically undercapitalized. …

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