The Federal Reserve has adopted a rule that illustrates a fundamental contradiction in Congress’s approach to financial reform: Legislators want to outlaw bailouts, but neither they nor regulators have done enough to make bailouts unnecessary.
The rule, mandated by the Dodd-Frank Act of 2010, prevents the Fed from providing emergency loans to individual institutions. The rule forbids the kind of targeted support that was offered to Bear Stearns and AIG during the 2008 crisis.
The goal is worthy. Companies should bear responsibility for their actions, not stick taxpayers with the bill.
That said, curbing the Fed’s emergency powers won’t by itself end the need for bailouts. Dodd-Frank offers a substitute, but it’s untested. Even with the best system in place, unforeseen events could require the kind of fast, flexible response that only an independent central bank can provide. For all its faults, the rescue of AIG in 2008 averted a much worse outcome.
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Limiting the Fed’s freedom of action makes it all the more vital to reduce the likelihood of such emergencies. The best way is more equity capital. Current rules require the largest U.S. banks to have only $5 in equity for each $100 in assets. Research and experience suggest that sharply increasing capital requirements would benefit the economy by enhancing banks’ capacity to take risks.
Instead of making bailouts illegal, the right response would be to make the system more resilient in the first place.