The Federal Reserve Board on Monday approved a proposal to curb its emergency lending powers, a change demanded by Congress after the central bank's controversial decision to aid AIG, Citigroup and others in 2008.
The rule, unanimously approved by the Fed's Washington-based board in an open meeting, requires that any future emergency lending be only "broad-based" to address larger financial market problems, and not tailored to specific firms.
The 2010 Dodd-Frank financial reform law instructed the Fed to curtail emergency loans to individual companies and prohibited it from lending to firms that were insolvent.
While some at the Fed worry the new rules will hamper the central bank's response in future crises, some politicians have said the proposed regulations are too imprecise, for example in defining insolvency, to prevent the types of deals done in 2008.
The final regulations approved on Monday tried to address some of those concerns. Under the proposal, at least five firms would have to be eligible to participate in any future crisis lending program. To avoid lending to insolvent companies, the regulations also said no loans would be made to firms that had failed to pay "undisputed debts" in the previous 90 days.
Fed Governor Daniel Tarullo said during the meeting that the regulations would provide better balance between the Fed's need to respond in a crisis and the concern that helping specific companies considered "too big to fail" created the wrong incentives for managers at companies expecting to be bailed out.
There has been "a longstanding tension of confronting moral hazard with wanting to retain flexibility," said Tarullo, the Fed's point person on regulatory issues.
As the financial crisis intensified in 2008, the Fed invoked its little-used emergency lending power to stave off the failure of AIG and Bear Stearns, and help other "too big to fail" companies including Citigroup and Bank of America <BAC.N>.
The Fed also enacted a series of more general emergency programs, in all providing $710 billion in loans and guarantees. Those programs were separate from the much larger Fed asset and bond purchases known as quantitative easing.
The loans have been repaid and the guarantees ended, ultimately earning the Fed a net profit of $30 billion, according to a September Congressional Research Service review.
However the effort was criticized as overreach, arguably important in limiting the crisis but also not clearly in line with the intended use of the Fed's emergency authority. The Fed routinely lends money to banks on a short-term basis to smooth the operations of the financial system. That is part of why it exists.
But since the 1930s it has had the power to lend more broadly in a crisis.
The Fed's support of major banks and non-financial firms highlighted the risks of having companies that are considered too big to fail, and of the implicit promise that they would be rescued. The Dodd-Frank reforms reined in those powers, and the rules approved on Monday put those Dodd-Frank provisions into effect.
(Reporting by Howard Schneider; Editing by Meredith Mazzilli, Andrea Ricci and Nick Zieminski)