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Federal Reserve Emergency Lending as a Coronavirus Response

posted by Adam Levitin

Senator Elizabeth Warren has put out a plan for mitigating the economic fallout from the coronavirus. Of particular note is that she is proposing having the Federal Reserve use its emergency lending power to support businesses affected by the coronavirus in order to ensure that they are able to provide paid health care leave to affected employees and avoid mass layoffs.  

This post addresses whether the Fed has the legal authority for such lending, what precedent exists, how it differs materially from the 2008 bailouts, and why it's a good idea. (Full disclosure: I consulted with the Warren campaign on this plan.)  

Does the Fed have legal authority?  

The Fed has very clear legal authority to engage in emergency lending, and it can put whatever conditions it wants on such lending. This one ain’t even close. Anyone who says that the Fed lacks authority is uninformed. 

Section 13(3) of the Federal Reserve Act, provides that in “unusual and exigent circumstances” the Fed may “discount for any participant in any program or facility with broad-based eligibility notes…secured to the satisfaction of the” Fed. The Fed’s regulations require that the borrower not be insolvent and that there be evidence that the borrower is unable to secured adequate credit accommodations from other banking institutions. 

The Fed would need to authorize use of 13(3) with a vote of at least five governors, but the other requirements aren’t much of an obstacle. A program like what Senator Warren is proposing would be inherently broad-based with more than five eligible participants. It would only be available for companies that are solvent, meaning not in bankruptcy and generally paying their bills as they come due. The only real question is about the ability to secure other adequate credit accommodations. That’s an evidentiary question that only has to be met to the Fed’s satisfaction, which is pretty flexible and could be done on the basis of market conditions, not company-specific evidence. 

The terms of the loans are an open question. But the Fed gets to condition its offer however it wants, whether it's on paid medical leave or refraining from mass layoffs. This is just a matter of the Fed using its economic leverage to extract terms that favor the policy goals of the emergency lending the first place. All that the regulations require is that the loan be at a “penalty rate,” following Bagehot’s advice, but “penalty rate” is defined in a way that it doesn’t have to mean much of anything. And indeed, a penalty rate is counterproductive if the goal is to infuse firms with the cash to weather the coronavirus storm.

Instead, the key provision that Senator Warren is urging is that eligibility for the loans be related to prevention of mass layoffs so as to minimize the domino effect from supply chain disruptions due to coronavirus. This does not mean that firms that get Fed funding can’t fire employees for cause; the point is preservation of employment writ large. And indeed, let’s remember that the Fed (and not just the Fed’s Open Markets Committee) is charged with the goal of “maximum employment” as part of its dual mandate. 

It's worth noting that the Small Business Administration also has emergency lending authority (not limited to small businesses) in response to "major disasters," but that term is defined by statute to be only physical natural disasters, not pandemics. The SBA, of course, has an appropriated budget. The Fed does not, so it has more flexibility.   

But, I thought the Dodd-Frank Act said “No Bailouts.” 

The Dodd-Frank Act placed some limitations on the Fed’s emergency lending power, but it largely preserved it. The Dodd-Frank Act did not prohibit “bailouts.” Instead, it amended section 13(3) to require that the Fed only lend as part of programs with “broad-based eligibility,” so there couldn’t be something like a special AIG-only program. But Dodd-Frank deliberately preserved the Fed’s ability to support the market generally in times of crisis. 

Is there any precedent for this sort of emergency lending action by the Fed?

Yes, there’s a lot of precedent. Section 13(3) has been around since the Depression. It was enacted in 1932 as part of a set of amendments to the Reconstruction Finance Corporation Act. The RFC was created in January 1932 by the Hoover administration (those crazy interventionists!) to engage in direct lending to the industrial economy and local government units. Section 13(3) was part of a set of July 1932 amendments that expanded the RFC’s power.

Now some critics have suggested that the RFC was different than the use of 13(3) because it was done legislatively. That's wrong. Congress passed enabling legislation that both authorized the RFC and the Fed to engage in emergency lending. It did not direct any particular lending by either agency. The Fed's deployment of 13(3) is an exercise of regulatory discretion, the same way the RFC's lending was. There's really no legal difference. 

So turning back to precedent, the Fed used 13(3) extensively during the Depression to support banks (and occasionally nonbanks), but there’s also plenty of more recent precedent.  

First, the Fed guarantied payment of all checks in the checking system for about a week after 9/11. US airspace was closed following 9/11, and that was hugely disruptive to the payment system. At the time all checks cleared physically, meaning that the actual paper had to be moved around the country. I’m not sure what authority the Fed used, but it was effectively lending at an interest free rate to everyone who wrote a check in that time period—that was billions, if not trillions of dollars that the Fed floated.  And when NY-area airspace reopened, the first planes in the air were Fed-Ex planes out of Teeterboro airport carrying checks for the NY Fed. Congress then passed the Check21 Act, which authorizes (but does not require) checks to clear via image exchange. 

Second, in 2008-2010, the Fed used 13(3) extensively as its authority for all kinds of lending programs. Most relevant was the Commercial Paper Funding Facility, which was set up to ensure that real economy businesses had adequate access to working capital. The CPFF was a more convoluted and indirect way of doing direct lending. But the goal was the same—providing real economy businesses with sufficient working capital. 

Won't this politicize the Fed?

If you think that the Fed isn't already and hasn't always been a political entity, you haven't been paying attention. The Fed likes to tell a story of "independence," and it is not subject to partisan politics the same way that say, Treasury is. But that doesn't mean that it is an apolitical entity, just that its politics are somewhat different. It's not as if politics is somehow constrained only to the realm of fiscal policy, not monetary policy. For example, decisions on interest rates benefit savers (creditors) or spenders (debtors)--there's a politics there.  

But putting that general point aside, would use of 13(3) somehow corrupt the Fed's politics? It's hard to see how. Any 13(3) program must be "broad-based" so the Fed can't play favorites in the economy. Moreover, Warren's proposed use of 13(3)--temporary emergency lending to fund paid medical leave and to prevent the spillovers from mass layoffs doesn't seem particularly political--it's not as if the GOP is going to be opposed to fiscal measures, even if they're through the Fed.  

Wait, I thought Warren was opposed to bailouts…

Warren is absolutely opposed to bailouts. She made her bones holding Treasury responsible for its decisions in 2008-2010. (Again, full disclosure: I worked for her when she chaired the Congressional Oversight Panel.) And she’s left her mark on the law. The Fed’s implementing rules for section 13(3), which tightened its requirements, look an awful lot like the proposed bipartisan Warren-Vitter bill in terms of the broad-based eligibility definition and the penalty rate requirement. 

So Warren is opposed to bailouts. But this isn’t a bailout. Mitigating the economic fallout from coronavirus is a very different situation than bank bailouts in 2008. Not every use of the Fed’s emergency lending power is a “bailout.” 

A bailout rescues a firm from the consequences of its own bad behavior. That’s not what’s going on here. The banks that ran into trouble in 2008 got into trouble because of their own reckless lending. The bank bailouts were so distasteful because the banks had privatized their profits, but socialized their losses. That’s not capitalism. That’s just corruption. 

In contrast, the coronavirus is a classic example of what law calls “force majeur”—Acts of God and the like that are beyond the ability of businesses to control. Indeed, it isn’t possible for businesses to insure against a supply chain disruption caused by a pandemic. The government is the insurer of last resort—when all else fails, government will step in and should. 

Warren’s objection to the 2008 bank bailouts were also because the banks got bailed out without the Fed using its leverage to force the banks to hold off on foreclosures. It was an epic mistake because of the spillover effects from foreclosures. The whole point of Warren’s urging the Fed to engage in emergency lending now is to prevent economic spillover effects from coronavirus by giving firms the access to working capital that will give them the liquidity to wait out the pandemic without mass layoffs that will only drive down the economy further. The Fed can and should tie its emergency lending to preservation of employment.

OK, that’s all great.  But is it a good idea? 

Yes. It’s one tool in the economic response toolkit and alone is not enough. Warren has put forth a broader set of policy responses to mitigate the economic effects of the coronavirus pandemic—fiscal stimulus, extension of government insurance programs and other health-care related actions—but also the use of the Fed’s emergency lending power. 

Fiscal tools can be very targeted, but so can 13(3), and the more common use of fiscal tools is not fine-grained targeting, but moves like block grants. Moreover, fiscal stimulus doesn't move funds on day one, and time is of the essence in preventing economic spillover effects from coronavirus. Monetary tools go into effect immediately, and 13(3) is a very targeted monetary tool that lets the Fed get funding to hard-pressed firms extremely quickly. The Fed can be nimbler with 13(3) than Congress with a fiscal stimulus package.  

It’s also important to understand why emergency lending is better than a rate cut, which is usually tool # 1 in the Fed's toolkit (or maybe tool #1.5 if you count messaging as a separate tool). A rate cut is a blunt policy tool. It creates cheaper credit across the board. It isn't targeted to firms that need working capital. It funds acquisitions as well, for example.

More importantly, a rate cut is simply non-responsive to the problem. When the Fed engaged in a rate cut in response to the Trump tariffs, that made sense as the tariffs increased the cost of supply chains and the rate cut offset that to some degree. The problem today is frozen supply chains, not costlier ones. No amount of cheap credit will unfreeze those supply chains (it will only help companies that don't need it), and the Fed needs to keep its powder dry for the coming recession. We’re already close enough to zero rates that the Fed doesn’t have much ammo in its magazine.

For the Fed to throw away its shot here would be wasteful and perhaps counterproductive. Markets are smart enough to realize that a rate cut isn’t a solution, and it could make the Fed look hapless. If the Fed announces that it will be prepared to undertake whatever lending is necessary to prevent mass layoffs and to ensure that workers don't come in sick because of lack of paid leave and thus spread the virus, it will go a long way to instilling market confidence that the spillover effects of the coronavirus will be limited. That could be the difference between a recession and something much worse. As Hank Paulson famously observed in 2008: "If you have a bazooka in your pocket and people know it, you probably won't have to use it." Section 13(3) is a bazooka. 

Warren’s got a plan. (And wow, did she pull it together fast!). It shows a willingness to use whatever tools are around to address a crisis. The Fed needs to make clear that it has a plan too, and it needs to show that its plan involves more than a perfunctory rate cut that will do nothing to assuage reasonable market concerns about broader spillover effects. Now is the time for the Fed to let everyone know that it has a bazooka in its pocket and is prepared to use it. 


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