Congress is playing with fire over Fed power

The United States House of Representatives recently passed the Fed Oversight Reform and Modernization (FORM) Act, which would effectively eliminate the Federal Reserve's authority to act as a lender of last resort to much of the financial system.

Without a strong lender of last resort in a financial crisis, as we had in 2008, our financial system could collapse, and our economy and country with it, all in a matter of weeks as people panic unable to get their money.

The FORM Act, as Fed Chair Janet Yellen wrote in a letter to congressional leaders before the vote, would effectively prohibit the Fed from lending to non-banks in a crisis.

Fed Chair Janet Yellen
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Fed Chair Janet Yellen

Lending to non-banks, often called shadow banks — including money market mutual funds, broker-dealers and non-financial corporations — was a crucial part of the government's response to the contagion that spread throughout our financial system in 2008.

Contagion occurs when short-term creditors run on solvent institutions, or institutions that would be solvent but for the fire sale of assets that are necessary to fund withdrawals.

History has taught us that contagion is an unavoidable risk of financial intermediation and that a strong lender of last resort is necessary to prevent it. However, this is not a government "bailout," which is a capital injection into an insolvent firm.

Our financial system remains exposed to contagion. I estimate that there is over $7 trillion in runnable short-term debt. Moreover, non-banks issue about 60 percent of these liabilities.

During the crisis, the Federal Reserve provided non-banks with $930.6 billion in loans and general market liquidity. So the ability to lend to non-banks in a crisis is a crucial matter, and will become even more important, as over regulation of banks fuels the further growth of the shadow banking sector.

Under the FORM Act, the Federal Reserve could only lend to non-banks if at least nine of the 12 presidents of the Federal Reserve Banks vote in the affirmative.

This would unduly slow the Federal Reserve's ability to quickly respond to an emerging crisis. Further, it would allow 4 dissenting Reserve Bank presidents to prevent Federal Reserve action, over the collective judgment of the Federal Reserve Board and the eight other Reserve Bank presidents.

Second, the Federal Reserve could only lend to non-banks if all "federal banking regulators" with jurisdiction over the borrower, likely including the Consumer Financial Protection Bureau, certify that the borrower is solvent. This same provision is included in a similar bill by Senators Elizabeth Warren and David Vitter pending action in the Senate. This requirement would be comical if it were not so deadly.

Do we really want to provide a consumer protection agency with the power to veto the Fed's power to act in a crisis?

Third, the bill would preclude the Federal Reserve from lending to entities that are not "financial institutions." In other words, non-financial corporations would be unable to borrow from the Federal Reserve, as solvent non-financial corporations, like McDonalds, Caterpillar, Harley-Davidson, Ford, and Verizon, so sorely needed to do, and did, in the 2008 crisis.

Of course, a House vote for the FORM Act is far short of actual legislation. Senate passage of the FORM Act, or similar legislation, is unlikely at least in this Congress. If it were to pass Congress, a presidential veto would stand in the way as well.

But even without passage, the message to the Federal Reserve is clear: While former Fed Chairman Ben Bernanke could not anticipate that the Fed would be politically vilified for "bailing out" Wall Street by exercising its traditional power as lender of last resort, this prospect will be abundantly clear to the next Fed chair who has to deal with a crisis — and even clearer to the market.

This political environment reduces the likelihood that the Federal Reserve will respond quickly and decisively to an emerging financial crisis.

Congress has reason to be concerned about additional Federal Reserve transparency. The Federal Reserve needs to establish a clearer framework for exercising its lender of last resort powers — it could well learn a lot from the British system in this regard. The Fed has taken a small step in that direction by recently clarifying certain of its emergency lending powers.

But the need for additional transparency does not justify the passing of legislation that would expose our financial and economic system to collapse.

Commentary by Hal S. Scott, a professor at Harvard Law School and the director of the non-profit Committee on Capital-Markets Regulation. He is also the author of the law-school textbook "International Finance: Transactions, Policy and Regulation" and "The Global Financial Crisis." Follow him on Twitter @HalScott_HLS.