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Fed's Power Would Be Curtailed by Financial Reform Bill

Published: Wednesday, 28 Oct 2009 | 3:58 PM ET

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By: Steve Liesman
Senior Economics Reporter

Is the Fed's independence for setting monetary policy the next thing to go?

You have to read to the last page, 253, of the regulatory reform bill unveiled Tuesday night to find one of the most historic parts. On that page, the proposed law would amend the Federal Reserve Act to take away the central bank's independent ability to bail out a specific company.

The new rule would require "written concurrence of the Secretary of the Treasury" if the Fed provides any assistance to a specific company.

Moreover, the Fed can't create a unique type of vehicle to bail out a company a la the Maiden Lane investment companies. It has to be from a facility available to all.

Bottom line: the Fed could not have stepped in over those fateful nights and bailed out Bear Stearns or AIG. (For the record, the insurance wrappers for Citigroup [C Loading... () ] and Bank of America [BAC Loading... () ] would appear to have qualified.)

How concerned should markets be about this? As with many things to do with the Fed, there are philosophical and practical issues to consider.

Asked about this issue in July, Fed Chairman Ben Bernanke said its bailouts were all done in close consultation with the Treasury.

Also from a practical standpoint, if the Barney Frank bill becomes law it will give the government authority to resolve these big, systemically important behemoths. So the Fed should not have a need to do weekend bailout gigs.

Philosophically, though, it gets more complicated. Central banks have been acting as the "lender-of-last-resort" apart from politicians for a long time. It's one of the reasons why you have central banks and not just Treasuries: some entity that can cut through the political fog on the eve of disaster and see clearly the need to step in and lend.

Walter Bagehot is famous for writing in the 19th century about the need for central banks "to lend freely" in times of panic. The ability to do so — and the clear understanding that it can — is thought by some economists to actually underpin stability of the financial system. (Some economists argue that all it does is increase the risks that companies take — moral hazard).