Should the Fed be Allowed to Lend to Insolvent Businesses?

Abstract

The Dodd-Frank Act of 2010 was passed in response to the financial crisis beginning in 2007 known as the Great Recession. The purpose of the Act is "To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes." The Act creates the first ever legal mandate prohibiting the Federal Reserve from lending to insolvent institutions. Is this mandate a good thing? According to a vast portion of the economic literature on the proper role of lender of last resort, a central bank should not lend to an insolvent business. However, the Great Recession has made clear that under certain circumstances the bailout of an insolvent firm may be the best policy option.