What Is Emergency Credit?
Emergency credit is money loaned by the Federal Reserve to a bank or other financial institution which has an immediate need for cash and no alternative sources of credit. These loans are usually made in response to a financial crisis and are colloquially referred to as bailout loans.
Emergency credit is extended by the Federal Reserve in order to reduce the economic consequences of severe financial shocks such as the credit crunch which occurred at the start of the 2007-2008 financial crisis.
Emergency credit is usually extended for a period of 30 days or more.
- Emergency credit is a type of loan granted by government institutions to support financial institutions in situations where sufficient private credit is otherwise not available.
- It is designed to restore liquidity to financial markets in order to reduce the risk of systemic collapse.
- Emergency credit was used extensively by the federal government in the response to the 2007-2008 financial crisis.
How Emergency Credit Works
The modern legal basis for the emergency credit system stems from the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which was passed in 1991. This law amended the Federal Reserve Act to broaden the scope of financial bailouts permissible for institutions insured by the Federal Deposit Insurance Corporation (FDIC).
To accomplish this, the FDICIA authorized the FDIC to borrow directly from the U.S. Treasury in order to provide bailouts for distressed banks in times of dire financial stress.
In 2010, following the tumultuous financial crisis that began in 2007, the Dodd-Frank Wall Street Reform and Consumer Protection Act made further amendments to the Federal Reserve Act. Specifically, the Dodd-Frank reforms restricted the Federal Reserve’s authority to issue bailouts, particularly in relation to institutions that are otherwise insolvent.
These rules were further amended in 2015, incorporating the requirement that any new emergency lending programs must obtain prior approval from the Secretary of the Treasury. The 2015 reforms also instituted guidelines for the interest rates used in emergency credit transactions, specifying that these rates must be set at a premium to the interest rates prevalent under normal market conditions.
The purpose of these amendments was to prevent financial institutions from tapping into emergency credit facilities at any time of normal market conditions. In that case, the government could effectively be competing with private lenders.
The amendments defined the emergency credit program as available only in situations when no alternative sources of credit are available.
The Federal Reserve is the "lender of last resort."
The Federal Reserve created or expanded a number of its emergency credit programs in order to shore up small- and medium-sized businesses that were struggling to survive through the COVID-19 pandemic.
Real World Example of Emergency Credit
According to a 2017 study published by the Olin Business School at Washington University in St. Louis, emergency credit is an effective means of stabilizing financial markets.
Researchers found that, during the 2007-2008 financial crisis, more than 2,000 banks took advantage of emergency credit offered by the Federal Reserve. The availability of this emergency credit increased bank lending without increasing the riskiness of banks’ lending choices.