Definition of emergency credit


What is emergency credit?

Emergency credit is money loaned by the Federal Reserve to a bank or other financial institution that has an immediate need for cash and has no alternative sources of credit. These loans are generally made in response to a financial crisis and are colloquially known as rescue loans.

The Federal Reserve grants emergency credit to reduce the economic consequences of severe financial crises, such as the credit crisis that occurred at the beginning of the 2007-2008 financial crisis.

Emergency credit generally extends for a period 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 there is not enough private credit available.
  • It is designed to restore liquidity to financial markets in order to reduce the risk of systemic collapse.
  • The emergency credit was used extensively by the federal government in response to the financial crisis of 2007-2008.

How Emergency Credit Works

The modern legal basis for the emergency credit system stems from the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which was passed in 1991. This act amended the Federal Reserve Act to broaden the scope of the financial redemptions allowed for institutions insured by the Federal Deposit. Insurance Corporation (FDIC).

To accomplish this, the FDICIA authorized the FDIC to borrow directly from the United States Treasury to provide bailouts to distressed banks in times of severe 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 otherwise insolvent institutions.

These rules were further amended in 2015, incorporating the requirement that any new emergency loan program must obtain prior approval from the Secretary of the Treasury. The 2015 reforms also instituted guidelines for the interest rates used in emergency credit transactions, specifying that these rates should be set at a premium to the prevailing interest rates under normal market conditions.

The purpose of these modifications was to prevent financial institutions from resorting to emergency credit lines at any time during normal market conditions. In that case, the government could be effectively competing with private lenders.

The amendments defined the emergency credit program as available only in situations where there are no alternative sources of credit available.

The Federal Reserve is the “lender of last resort.”

The Federal Reserve created or expanded several of its emergency credit programs to prop up small and medium-sized businesses struggling to survive the COVID-19 pandemic.

Real 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.

The researchers found that, during the financial crisis of 2007-2008, 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 risk of banks’ credit options.

www.investopedia.com

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Mark Holland

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