What is Emergency Credit
Emergency credit is a loan given by a Federal Reserve Bank to a non-bank institution or organization when no other source of credit is available. The organization in need must examine all other potential sources of funds first. Most of these loans are longer-term, usually more than 30 days.
BREAKING DOWN Emergency Credit
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) amended the Federal Reserve Act to expand the scope of bailouts for federally insured depository institutions, allowing the FDIC to borrow directly from the Treasury in order to help failed banks, and to use the least-expensive method to bail out failed banks. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further amended the Federal Reserve Act. It restricted the Federal Reserve Board’s authority to extend emergency credit to facilities and programs with demonstrated “broad-based eligibility” and that were established under the approval of the Secretary of the Treasury. Furthermore, the Dodd-Frank Act prohibited the extension of emergency credit to insolvent organizations, and required the Federal Reserve Board to approve procedures to prevent the extension of emergency credit to insolvent borrowers.
Final Procedures for Emergency Lending
In 2015, the Federal Reserve established a final procedure for emergency lending procedures as required by Section 13(3) of the Federal Reserve Act as amended by the Dodd-Frank Act. The final rule clarifies many of the requirements implemented by Dodd-Frank. For example, the final rule defines “broad-based” as a facility or program in which at least five entities can participate, and which was not created or designed in order to assist failing firms. The final rule also broadens the definition of insolvency, incorporates the requirement that emergency lending programs be approved by the secretary of the Treasury, and sets guidelines for the establishment of an interest rate for emergency credit.
Emergency Credit Interest Rates
Under the final rule created by the Federal Reserve in 2015, interest rates for emergency lending are to be set at a rate that is premium to the normal market rate. The rate should also offer borrowers liquidity in unusual circumstances, while encouraging repayment and discouraging use of emergency lending facilities as the market normalizes.
Effectiveness 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 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.