Is the Financial System Better Off?

By: Anthony DiLorenzo, M.S.                                                                                                                                                         Staff Accountant – WithumSmith+Brown, PC

The Financial crisis of 2008 – 2009 is now almost 8 years removed, but the question of how prepared The United States is for another crisis is still subject to much debate. Looking back at the bailouts of the “to big to fail” institutions such as Bear Sterns, the Fed was able to move very quickly; and without the normal red tape that covers Washington from end to end. This arguably saved the entire economic system from a complete meltdown. Today, most of the loans given were paid back with interest. To date the government has made a net profit of over $55 billion on those emergency loans and bailouts.

The subprime mortgage issue began to really fester in the summer of 2007. In March 2008, Bear Stearns became the first high profile victim. The Fed quickly stepped in and bailed out Bear with emergency funding. It then backed a fire sale of the institution to JP Morgan. A similar scenario would be repeated many times over the next year. The main reason the Fed was able to act so quickly was due to a little know clause in the Federal Reserve Act – Section 13 (3). In extreme situations it allowed the Fed to lend to any individual, partnership, or corporation if they were “unable to secure adequate credit accommodations from other banking institutions.”

In a future crisis, the Fed should be expected to invoke this clause, correct? Not so fast. The Dodd-Frank Act of 2010 severely limited the Central banks’ ability to act. Title XI of the Act now adds the Washington’s red tape to a future crisis. First, any emergency lending by the Fed must be discussed and ultimately approved by the Secretary of the Treasury. Also, a full report must be given to congress within 7 days of the loan. Second, the borrowing institutions must be solvent, which somewhat defeats the purpose of an emergency loan in a crisis. Third, and probably the most severe restriction is the Fed cannot lend to just a single institution. It can only “provide liquidity to the financial system.”

These provisions were all put into place to “ensure protection for the taxpayer”. In reality, it seems the taxpayer would be far worse off than before the financial meltdown. In a future crisis the Fed may be more of an onlooker than a leader. Most importantly, it will be unable to act as a true lender of last resort. While there are good aspects of The Dodd-Frank Act, these provisions seem to have been an overreaction to the public outcry.

Overall, Title XI of the Dodd-Frank Act seems to make the financial system worse off to weather a future economic shock. The only focus of legislation should be on how to limit the interconnectivity of large institutions before another crisis, not on how to avoid helping during one.

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