The Federal Reserve Board has clarified its procedures for emergency lending to banking institutions and placed new restrictions on future bailouts that were required by the Dodd-Frank Act.
Among the limitations included in the Dodd-Frank Act as a response to critics of financial crisis bailouts were that emergency lending only be extended in "unusual and exigent circumstances" and to programs and facilities with “broad-based eligibility.” The Federal Reserve Bank must also obtain evidence that the borrower is unable to secure adequate credit from other banking institutions.
A final rule approved by the Federal Reserve Board on Monday defines "broad-based" to mean a program or facility that is not designed for the purpose of aiding any number of failing firms and in which at least five entities would be eligible to participate.
Responding to the Dodd-Frank prohibition on emergency lending to insolvent borrowers, the final rule broadens the definition of insolvency to cover borrowers who fail to pay undisputed debts as they become due during the 90 days prior to borrowing or who are determined to be insolvent. Throughout the public comment process that shaped the final rule, the Fed was urged to adopt a broad definition of insolvency that includes situations where a company has not yet entered formal bankruptcy or resolution proceedings, but may be insolvent from an accounting or other perspective.
The rule also incorporates a requirement that emergency credit programs, authorized by Section 13(3) of the Federal Reserve Act, must be approved by the Secretary of the Treasury.
While past practice when extending emergency lending has been to attach penalties to interest rate requirements to encourage prompt repayment, the final rule now requires that the interest rate be set at a level that is a premium to the market rate in normal circumstances, affords liquidity in unusual and exigent circumstances, encourages repayment, and discourages use of the program as circumstances normalize.
The final rule takes effect on Jan. 1, 2016.