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Did the Federal Reserve's lending during the recession violate the law?

Critics of the Federal Reserve have questioned both the legality and the propriety of the agency's lending to banks during the financial crisis. In "Federal Reserve Lending to Troubled Banks During the Financial Crisis, 2007-2010" (Review, May/June 2012, Federal Reserve Bank of St. Louis, pp. 221242, www.research.stlouisfed.org/ publications/review/12/05/221242Gilbert.pdf), Federal Reserve authors R. Alton Gilbert, Kevin L. Kliesen, Andrew P. Meyer, and David C. Wheelock respond to the critics by addressing two relevant questions: (1) Did the Federal Reserve violate the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA)--which sets out strict terms under which lending to undercapitalized banks can take place--by lending inappropriately to undercapitalized banks? (2) Was Federal Reserve lending to banks that later failed an unjustifiably large fraction of those banks' deposit liabilities during their last year of operation?

The Federal Reserve lends money to banks in many ways. One important one is the discount window, which has been offering three kinds of credit since the Federal Reserve system was established in 1913. Another way, whose use overshadowed that of the discount window from 2008 through mid-2010, is the Term Auction Facility (TAF), which was established during the financial crisis in response to concerns that some banks might be reluctant to borrow via the discount window.

Lending through either of these channels is governed by the FDICIA, which imposes limits on the number of days that the Federal Reserve is permitted to provide funds to undercapitalized banks.

The act states that the Federal Reserve may lend money to undercapitalized banks (a bank is judged to be undercapitalized by a complicated formula giving the ratios of different classifications of the bank's capital as a percentage of its assets) under two conditions: (1) The loan may not be outstanding for more than 60 days in any 120-day period and (2) loans may not extend more than 5 days from the time a bank becomes critically undercapitalized (its ratio of tangible equity to total assets should be no more than 2 percent). So the first question becomes, more specifically, "Did the Federal Reserve violate either of these conditions in lending to undercapitalized banks?"

After considerable analysis in which various criteria for identifying when a bank becomes critically undercapitalized are examined, the authors find that, under any of the criteria they propose, the Federal Reserve never knowingly violated the 60-out-of-120-day condition, and most loans were for considerably fewer days than the maximum permitted. A total of 53 banks, during the time they were undercapitalized, borrowed from the Federal Reserve from August 2007 through March 2010, most for 5 days or less, and all except one borrowed for less than 60 days. One undercapitalized bank did borrow for 72 days, but its classification as an undercapitalized bank was pending for a time, during which the Federal Reserve stopped lending to it; by the time the classification became final, the bank was no longer borrowing from the Federal Reserve. Similarly, the Federal Reserve lent to only one critically undercapitalized bank during the entire financial crisis, and that bank was not undercapitalized (much less, critically undercapitalized) at the time credit was extended to it. Thus, the Federal Reserve violated neither the letter nor the spirit of the FDICIA in its lending practices during the 2007-2010 financial crises.

Regarding the second question, which deals with loans to critically undercapitalized banks, the authors find that a solid majority (67 percent) of banks which failed during 2008-2010 did not borrow from the Federal Reserve in their last year of operation. Hence, although 33 percent of banks which failed during that period did borrow from the Federal Reserve, the fact that so many did not means that Federal Reserve credit did not make up a large percentage of the deposit liabilities of banks that failed from 2008 to 2010 during their last year of operation. Consequently, with regard to loans to critically undercapitalized banks, the Federal Reserve did not violate the terms of the FDICIA. Even if we cannot attribute the Federal Reserve lending practices during the 20072010 financial crisis to the FDICIA, we can acknowledge that the practices were consistent with the congressional intent of the act.
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Title Annotation:Precis
Publication:Monthly Labor Review
Geographic Code:1USA
Date:Sep 1, 2012
Words:699
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