Dodd–Frank also requires that all lending to nonbanks be subject to “the prior approval of the Secretary of the Treasury.”14 The Act requires that the “policies and procedures governing emergency lending” be promulgated in consultation with the Secretary of the Treasury and that, as already discussed, no program or facility under Section 13(3) may be established “without the prior approval of the Secretary of the Treasury.” This provision effectively withdraws exclusive control over the decision to loan to nonbanks from the Federal Reserve Board, an exclusive power it had during the crisis. It severely limits the ability of the Federal Reserve to respond independently to a crisis. The Dodd–Frank Act’s requirements for Treasury approval of Federal Reserve actions will arguably politicize the
decision of how to deal with contagion and create significant market uncertainty, thereby accelerating the outbreak and pace of future runs.
In some respects the new requirements recall the early days of the Fed’s existence when political interference with all central banking operations was a serious concern.
Economist Allan Meltzer has conducted extensive research on the Federal Reserve’s early struggles to maintain its independence.15 The Federal Reserve was formed just one year before the start of World War I, and Meltzer finds that the Federal Reserve’s early years were spent providing support to the Treasury’s war-financing efforts.16 This arrangement placed the Federal Reserve in a position of relative subservience to the Treasury,
symbolized by the fact that the Federal Reserve originally met in a Treasury Department conference room.17 “[T]he Secretary of the Treasury was the ex officio chairman of the Federal Reserve Board until 1935, who sat at the head of the table whenever he chose to attend meetings.”18 In particular, during World War I Federal Reserve officials explained that they allowed inflation risks to rise and rejected rate increases because such increases were “inadvisable from the point of view of Treasury’s plans.”19 The early Federal Reserve was also reluctant to oppose the Treasury in light of the Overman Act, which allowed the President to transfer Federal Reserve responsibilities to another agency (e.g., the
Treasury) during the wartime period.20 Overall, Meltzer notes that throughout this early period, congressional officials blamed the Federal Reserve’s missteps on the agency’s lack of independence from political pressures.21 Meltzer concludes that the early Federal
Reserve “was too weak politically to slow or stop the postwar inflation and too uncertain about the political consequences of its actions to act decisively when the Treasury allowed it to act.”22 A former vice-chairman of the Federal Reserve, Frederick H. Schultz, has
described the period of maximum Treasury involvement with the Federal Reserve’s operations as a time of “politicized” decision-making.
After World War I the Federal Reserve attempted to assert its independence. Certain congressional members supported this endeavor and passed the Banking Act of 1935, a law that further centralized monetary decision-making power in the Federal Reserve.23 The primary objective of the Banking Act was to centralize authority in the Board of Governors and to make permanent some of the temporary exceptional measures discussed above.24 As previously mentioned, the Banking Act expanded the Federal Reserve’s lender-of-last-resort authorities by permitting Section 10(b) lending in other than “exceptional and exigent circumstances.”25 The Act greatly enhanced the Federal Reserve’s independence by removing the Secretary of the Treasury and the Comptroller of the Currency from the Board of Governors.26 Two years prior, the Banking Act of 1933 had established the Federal Open Market Committee (“FOMC”).27 However, the decisions of the FOMC with respect to open market operations were not binding on reserve
banks.28 The Banking Act of 1935 placed control of the FOMC in the Board of Governors, by ensuring that a majority of its members were members of the Board of Governors, and by making its decisions about open market operations binding on reserve banks.29
However, Meltzer finds that continued “[s]ubservience to the Treasury during the
[post–World War I] recovery … limited the effect of the legislation for a time.”30
Moreover the Federal Reserve returned to a deferential wartime role in the wake of World War II; during this period then Federal Reserve Chairman Marriner Stoddard Eccles
characterized his role as “a routine administrative job … [t]he Federal Reserve merely executed Treasury decisions.”31 After World War II the Federal Reserve obtained formal independence through the 1951 Accord, an agreement that freed the Federal Reserve from the Treasury-induced ceiling on interest rates.32 Meltzer notes that subsequent to the 1951 Accord, the Federal Reserve “[f]or the first time since 1934 … could look forward to conducting monetary actions without approval of the Treasury.”33 Federal Reserve
independence was thus achieved only after the early Federal Reserve struggled to accede to Treasury instruction. This initial subservience hindered the Federal Reserve’s ability to avoid political concerns and effectively combat shifting market environments.
It is interesting, given the long history of the Fed’s struggle to free itself from control of the Treasury, to look into the legislative history of Dodd–Frank’s new requirement for Treasury approval of Fed lending to nonbanks. The initial proposal for what amounts to a Treasury veto on the Fed’s lender-of-last-resort authority to nonbanks came from the Treasury itself. The Treasury’s June 17, 2009, Final Report on Financial Regulatory Reform, proposed to revise the Fed’s “emergency lending authority to improve accountability,” by requiring Treasury approval.34 Subsequently the Obama
administration, on July 22, 2009, introduced draft legislation containing the requirement that the Fed’s emergency lending authority have the “prior written approval of the
Secretary of the Treasury.”35 The House Republican bill introduced on July 23, 2009, also contained a requirement for Treasury Secretary approval, as well as a provision to allow for congressional disapproval of §13(3) authority.36 A November 3, 2009, bill by
Democratic Representative Barney Frank also contained a requirement of Treasury approval.37 By December 11, 2009, the bill that ultimately became the Dodd–Frank Act, House bill (HR 4173), not only contained a requirement of Treasury Secretary approval of lending programs but also added several further limitations to the Fed’s power of lender of last resort to nonbanks that were not adopted into the Dodd–Frank Act: certification by the President that an emergency exists, FSOC determination that a liquidity event exists, and congressional power to disapprove of any §13(3) program.38 HR 4173 ultimately passed the House, but only after two major recorded votes for resolving differences, and only after passing the Senate.39 The bill that was initially engrossed in the House on December 11, 2009, contained these additional restrictions on the Fed,40 as did the bill that was referred in the Senate on January 20, 2010.41 However, the amendment
engrossed in the Senate on May 20, 2010, substantially revised the provisions affecting the Federal Reserve, removing these restrictions.42
Why would the Treasury, headed by a Secretary who previously served as President of the New York Fed, propose such restrictions on the Fed? It is interesting in this regard to note that Geithner in his book Stress Test, while criticizing other restrictions on the Fed imposed by Dodd–Frank, never mentions this one, which arguably is one of the most
onerous. The reason is clear: he cannot criticize a provision that he himself sponsored. I asked Secretary Geithner, after he left office, why he did this. He responded that
sometimes the Treasury would want the Fed to act as lender of last resort when the Fed was reluctant to do so.43 And that is surely possible—in the crisis Paulson was urging Bernanke on. But requiring the Treasury to approve the Fed acting as lender of last resort does not accomplish that objective—the Treasury must approve the Fed’s request to lend, it cannot order the Fed to lend. As we will see later, the power of Treasury to compel
central bank lending does exist, however, in Japan and the United Kingdom.
So what was the real reason that Geithner made this proposal? I believe there are only two plausible reasons. First, this could just be a continuation of the historical battle for supremacy between the Treasury and the Fed. Treasury saw an opportunity to control the Fed and took it. While Geithner had served as president of the New York Fed, he had not been chairman of the Board, and outside his service at the Fed, he was a career Treasury official. A second possibility is that he was trying to forestall even worse outcomes in a Congress that was intent on punishing the Fed for bailing out Wall Street. This is
plausible given the congressional proposal to have the power to veto loans to particular nonbanks. In any event, Treasury control of the Fed was not proposed by conservative republicans but by the Obama Treasury itself.
Holders of short-term debt issued by failing financial institutions are extremely unlikely to accept the uncertainty inherent in an ad hoc lending regime that might be canceled at any time or simply never initiated at all,44 especially when the arbiter of the decision is the Secretary of the Treasury, a political appointee, not a an independent agency like the Fed. The risk that the Secretary will withhold lender-of-last-resort assistance from a
distressed financial institution at a critical moment prevents this assistance from serving its function as a guarantee, or even a near guarantee.45
In 2008, Secretary Paulson readily gave his support of Federal Reserve lending under 13(3), and would no doubt have given his formal approval if required. Some believe that in the future faced with the extreme consequences of not lending, the Secretary of
Treasury, staring over the precipice, will have to give approval. Former Fed Chairman Ben Bernanke, for example, pointed out that “the approval of the Treasury Secretary … is
basically okay, for Democratic reasons and because, generally speaking, the Treasury Secretary and the Fed chairman see pretty much eye to eye at trying to prevent the financial system from collapsing.”46 In his recent book, Bernanke further added:
“[§13(3)’s ability to lend to individual institutions] was one authority I was happy to lose.
We would still be able to use 13(3) to create emergency lending programs with broad eligibility such as our lending program for securities dealers or the facility to support money market funds, although we’d have to obtain the Treasury secretary’s permission first. I didn’t consider that much of a concession, since I couldn’t imagine a major
financial crisis in which the Fed and the Treasury would not work closely.” 47 But in the new post-crisis political environment, it is far from certain that Treasury approval will be given at all, or on a timely basis—most important, the market will think it is uncertain, and thus start to run before such a decision is even made. I read Bernanke’s comments as
accepting bad restrictions on the Fed in order to fend off even worse ones.
Even if a particular Fed action might be approved by the Treasury Secretary under 13(3), or could be taken for banks without Treasury approval through the discount window, the political environment for the Fed acting as lender-of-last-resort has changed, making it less likely the Fed would even exercise its lender of last resort authority in a crisis. After all, it has been widely criticized for “bailing out Wall Street” in the last crisis. A
cornerstone to the Fed’s authority as lender of last resort is its independence from
political forces; it is thus worrisome that Ben Bernanke believes Treasury approval may be required in a democracy—would he say the same for monetary policy? Fundamentally, Bernanke’s concession reflects the strong political attack on the power of the Fed as
lender of last resort. Arguably, the Fed’s role as a lender of last resort is even more
important than its role in conducting monetary policy, so the independence of the Fed as lender of last resort should be a top priority.