By Howard Schneider
WASHINGTON (Reuters) - The Federal Reserve Board on Monday adopted a rule that stops it from bailing out individual companies, a change that Congress demanded after the central bank's controversial decision to help rescue American International Group (AIG.N) and others during the financial crisis.
The rule is designed to help end the notion of individual financial companies being "too big to fail," by allowing the Fed to rescue only the broader financial system instead of individual companies. Under the rule, the Fed can make emergency loans that can potentially be used by at least five companies, but it cannot make more ad hoc rescues like its efforts to save AIG during the crisis.
The Fed adopted the rules after the 2010 Dodd-Frank financial reform law required the central bank to curtail emergency loans to individual companies and to insolvent companies. The final regulations define insolvent companies as those that had failed to pay "undisputed debts" in the previous 90 days.
Fed Governor Daniel Tarullo said during the meeting that the regulations would better balance the Fed's need to respond in a crisis with the concern that managers expecting a bailout in the worst-case scenario would be more likely to take big risks to try to turn their companies around in times of stress.
There has been "a longstanding tension of confronting moral hazard with wanting to retain flexibility," said Tarullo, the Fed's point person on regulatory issues.
As the financial crisis intensified in 2008, the Fed invoked its little-used emergency lending power to help stave off the failure of AIG. It also lent money to JPMorgan Chase & Co to help reduce the bank's potential losses from buying Bear Stearns, which was on the brink of collapse.
The Fed also enacted a series of more general emergency programs, in all providing $710 billion in loans and guarantees to a wide range of financial companies. Those programs were separate from the much larger Fed asset and bond purchases known as quantitative easing.
In September 2008, the Fed refused to bail out Lehman Brothers, which according to senior officials at the central bank was not solvent and therefore could not be rescued. The investment bank filed for bankruptcy in September 2008, even as other troubled financial companies, such as Citigroup Inc, (C.N) received multiple rescues from the government.
The Fed's crisis-era loans have been repaid and the guarantees ended, ultimately earning the central bank a net profit of $30 billion, according to a September Congressional Research Service review.
But critics have argued that the Fed overreached during the crisis, using its emergency authority in ways not clearly foreseen by lawmakers.
The Fed routinely lends money to banks on a short-term basis to smooth the operations of the financial system, which is part of its mandate. But since the 1930s, it has had the power to lend more broadly in a crisis.
(Reporting by Howard Schneider; Editing by Meredith Mazzilli, Andrea Ricci, Nick Zieminski, Dan Wilchins and Dan Grebler)