Elizabeth Warren's Next Crusade: Clamping Down On The Federal Reserve's 'Too Big To Fail' Bailouts

After the financial crisis, protesters nationwide filled streets with the chant, “Banks got bailed out, we got sold out.” The sentiment still resonates in Congress. On Wednesday, Sens. Elizabeth Warren, D-Mass., and David Vitter, R-La., proposed curbs on the Federal Reserve’s ability to extend emergency financing to ailing firms.

The bipartisan legislation comes as some lawmakers argue the 2010 Dodd-Frank Act was a regulatory overreach, while others worry it failed to end the era of “too big to fail” banks. A day after Sen. Richard Shelby, R-Ala., unveiled legislation that would roll back some key Dodd-Frank policies, Warren and Vitter have taken the opposite tack.

"It's no secret that Too Big to Fail is still around,” Vitter said in a statement. “If another financial crisis happened tomorrow -- and that's still a real risk -- nobody doubts that megabanks would be calling on the federal government to bail them out again.”

The Fed’s bailout powers, which were dialed back by the Dodd-Frank, would be further constrained under the bill, called the Bailout Prevention Act.

Under the proposed legislation, the Fed would have to seek congressional approval within 30 days of making any extraordinary loans to distressed institutions. Bailed-out firms would also be forced to pay a penalty interest rate 5 percent above a Treasury benchmark, a departure from the bargain rates they paid after the crisis.

In a surprise provision, the bill would also repeal a grandfather clause in '90s-era financial legislation that has given Goldman Sachs and Morgan Stanley unusually broad liberties to engage in commodities trading. Those controversial activities sparked a Senate investigation last year.

Moral Hazard

The Fed’s emergency lending program has come under sharp criticism from Warren and other financial reform hawks who fear that the era of "too big to fail" has hardly ended.

"If big financial institutions know they can get cheap cash from the Fed in a crisis, they have less incentive to manage their risks carefully -- which further increases the chance of another financial crisis," Warren said in a statement.

During the height of the crisis, the Federal Reserve quietly doled out massive, low-cost credit lines to banks and other financial institutions to keep them afloat. The secretive program extended loans totaling some $13 trillion to banks including Goldman Sachs, Citigroup and JPMorgan.

When the full scale of the bailouts came into view in 2011, critics lambasted the Fed, whose actions had created what they deemed a moral hazard: The emergency credit, they said, created an implicit guarantee that the Fed would provide a backstop to banks engaging in risky bets, strengthening the too-big-to-fail regime.

Sherrill Shaffer, a former chief economist at the New York Fed, said Fed officials were all too aware of the conundrum. In a telephone interview, he recalled a precrisis luncheon attended by industry representatives and Fed officials. “A banker raised the question of emergency lending. All of us in the Fed were basically sitting there looking down at our plates. No one wanted to say, ‘Yeah, we lend,’ precisely because of the moral hazard,” he said.

“But when push came to shove, we knew we would lend,” Shaffer continued. In the end, he said, “we gave him a very weaselly answer.”

Under the proposed legislation, Fed officials could give somewhat firmer answers. The bill would set more precise guidelines around when and how the Fed can lend during a financial downturn. Simon Johnson, MIT professor and former chief economist of the International Monetary Fund, called the bill “a major improvement to the emergency powers of the Federal Reserve System” in a statement.

Hard Constraints

Critics of the policies behind the bill, like former Fed board of governors member Donald Kohn, argue that the Dodd-Frank provisions are adequate in keeping the Fed from engaging in egregious emergency lending. Those rules include requirements that the Fed’s lending avoid individual insolvent institutions and be extended to a broad swath of firms.

But a 2013 Fed proposal to comply with those mandates didn't satisfy lawmakers. In a letter last year, 15 members of Congress said that the Fed’s plan “fails to strike the appropriate balance between promoting financial stability and mitigating moral hazard.”

To prevent what critics considered sweetheart deals for banks during the crisis, the bill would mandate that any Fed bailout be extended to at least five institutions. Further, Fed officials would have to explicitly certify that the targeted financial firms weren’t insolvent.

Still, such stringent policies could have drawbacks, Shaffer said. No one knows what the next crisis will look like, and regulators might need flexibility to address unknowns. “The imposition of hard constraints seems at best redundant and at worst takes away capabilities to reduce harm,” Shaffer said.