Is there any reason why the American people should be taxed to guarantee the debts of banks, any more than they should be taxed to guarantee the debts of other institutions, including the merchants, the industries, and the mills of the country? —Senator Carter Glass, 1933, quoted in Rixey Smith and Norman Beasley, Carter Glass: A Biography, p. 357, New York, NY: Da Capo Press (1939, reprint 1972).
The story of the third paragraph of Section 13 of the Federal Reserve Act (Section 13[3]) is one of the great “sleeper” or “mole” stories of all time in American banking history. This March, 76 years after its creation, the sleeper came vividly to life when the Federal Reserve used Section 13 (3) as the justification for the rescue of an investment bank, Bear Stearns. The action may signify a disturbing new era in federal monetary policy. Section 13 (3) in 1932 was enacted as part of a road construction measure designed to relieve unemployment during President Herbert Hoover’s reelection campaign. Subject to certain restrictions, Section 13 (3) authorizes Federal Reserve Banks, “in unusual and exigent circumstances,” to extend credit directly to “individuals, partnerships, and corporations.” The new statute proved to be so restricted that it was used only sparingly from 1932-1936. After 1936, although it was occasionally authorized, and was not actually used until the Bear Stearns rescue. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) contained a little-noticed amendment to Section 13 (3) that paved the way for access of investment banks to the Federal Reserve Banks' discount window. Advances to failing depository institutions had become an increasingly controversial issue in the run-up to FDICIA, particularly in the aftermath of a wave of bank and savings and loan failures in the late 1980s. That debate culminated in congressionally mandated limitations on Reserve Banks' advances to undercapitalized banks. But in a comparatively little-noticed amendment of the Reserve Banks' lending authority, FDICIA made what proved to be a significant revision to the emergency liquidity provisions of the Federal Reserve Act. As amended by FDICIA, Section 13 (3) now permits all nonbank firms to borrow at the discount window for emergency purposes under the same collateral terms afforded to banks. Previously, only a narrowly restricted set of loans and securities that most investment banks tended not to hold could be used as collateral under Section 13(3). Ironically, while the principal thrust of FDICIA was to limit or reduce the size and scope of federal bailouts, at least for federally insured depository institutions, the 1991 amendment of Section 13(3) effectively expanded the scope of future bailouts. When the Federal Reserve authorized Section 13(3) loans to Bear Stearns, an investment bank held comparatively little in the way of eligible trade finance bills and government securities, the type of paper originally eligible for discount. The circumstances were more than a little questionable. Like most investment banks, Bear Stearns held a large amount of stocks, corporate bonds, and claims for derivative instruments, none of which was eligible for discount under the pre-1991 rules. The required number of five members of the Board of Governors was not present at the Board on the day in question. One of them was out of town and ratified the vote when he returned, but the first loan already was in motion. Eventually, the credit extended for Bear Stearns mounted to about $30 billion, of which $28.9 billion is still outstanding, plus $1.2 billion of special credit related to the Bear Stearns rescue extended to the acquiring institution, JPMorgan Chase. The totals exceed $30 billion due to the accrual of interest. $30 billion is about 3.3 percent of the Federal Reserve’s balance sheet.
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AIER Research Fellow Walker F. Todd first raised the issues in this article in 1993. For a detailed analysis of Federal Reserve emergency credit under Section 13(3), see his article, “FDICIA’s Emergency Liquidity Provisions,” Economic Review (3Q1993), Federal Reserve Bank of Cleveland.
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