What Is Emergency Credit?

The term emergency credit refers to loans given by the Federal Reserve to other banks and institutions which have no alternative sources of credit available to them. They are colloquially referred to as “bailout loans.”

Emergency credit is used as a means of reducing the economic consequences of severe financial shocks, such as the credit crunch which occurred as part of the 2007-2008 financial crisis. Generally, emergency credit is long-term in nature, with maturities of 30 days or more.

Key Takeaways

  • 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 emergency credit 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 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. These 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 underlying philosophy of these interest rate regulations is that the recipient firm should not be tempted to rely on emergency credit facilities under any typical market conditions. In other words, these regulations seek to avoid a situation in which the government effectively competes with alternative private lending arrangements, instead seeking to restrict emergency credit for situations when no realistic alternatives are available in the private credit marketplace.

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.