In the last two decades, the Federal Reserve has intervened extensively in American financial markets in the face of relatively unique crises. Its reaction to these crises included the deployment of new programs which were markedly distinct in their scope from the Fed’s day-to-day operations.
Few public institutions are able to operate as quickly and independently as the central bank, yet this was not always so. Indeed, the provision in the Federal Reserve Act that permits it to take such extraordinary actions was not in the original legislation and was little used for decades after its introduction. Nonetheless, Section 13(3) has since been relied on in times of emergency and has become the Fed’s ‘break the glass’ provision.
Federal Reserve Act
A run on the Knickerbocker Trust Company triggered a financial panic of 1907. One legacy of that crisis was the formation of a ‘National Monetary Commission’ to study monetary and financial systems. The commission led eventually to the establishment of the Federal Reserve System in the United States. The Federal Reserve Act of 1913 primarily sought to address shortcomings in the American financial system. Among these was the need for an ‘elastic’ monetary base that could respond to seasonal and cyclical variations in the unmet need for credit.
Nonetheless, the Federal Reserve Act put strict limits on the Fed’s discretion; in its interactions with member banks, it could only purchase short-term private bills, Treasury bonds, or loans backed by these bonds. The Fed could not, however, make secured loans itself, even to banks against government bond collateral.
The powers of the Federal Reserve to address extraordinary circumstances were expanded by the addition of Section 13(3) to the Federal Reserve Act. This amendment was included in the Emergency Relief and Construction Act of 1932. Included in a bill mostly concerning road construction, the new provision gave the central bank powers that would allow it to address abnormal financial conditions. The insertion of this amendment into an otherwise unrelated bill was the work of Carter Glass, a Democratic Senator from Virginia, and Charles Hamlin, a member of the Federal Reserve Board, as the Fed’s Board of Governors was then known, who had previously served as its first chairman.
Section 13(3) allowed the central bank to extend credit to non-banks through its discount window. Again, under the Federal Reserve Act, these were not technically loans but purchases of assets at a discount, but nonetheless a form of financing. These powers were granted despite the trepidation of most lawmakers in expanding the Fed’s powers. Rather, it was a compromise of sorts, an alternative to another bill vetoed by President Herbert Hoover that would have given this sort of extraordinary lending power to another government entity, the Reconstruction Finance Corporation.
“In unusual and exigent circumstances, the Federal Reserve Board, by the affirmative vote of not less than five members, may authorize any Federal Reserve Bank … to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange …” – Portion of Section 13(3) of the Federal Reserve Act as added in 1932 (since amended)
The state of the country, clearly in unusual and exigent circumstances during the early years of the Great Depression, meant that Section 13(3) was soon invoked. However, despite all the measures taken to arrest and reverse the economic slide, it was barely used in practice. Able to lend to non-bank entities, the Federal Reserve extended financing to all sorts of businesses unable to get credit elsewhere. Essentially, the Fed attempted to lend directly to small and mid-sized businesses. Nonetheless, the total capital deployed amounted to a paltry sum. Though 123 loans were made over the subsequent four years under the 13(3) provision, the total amount lent was just $1.5 million. The single largest loan was for $300,000 extended to a typewriter manufacturer.
The use of 13(3) during the Great Depression was a non-event. The low take-up was a result of stringent conditions and the introduction of more favorable programs soon thereafter, especially under the Industrial Advances Act. Under 13(3), the collateral that could be lent against was limited and lending under 13(3) required that five members of the Federal Reserve Board approve the loan.
The Fed engaged in more substantial direct lending under a different section of the Federal Reserve Act, Section 13(b). Like 13(3), this provision was added via an amendment, specifically one approved by the Industrial Advances Act of 1934. The legislation allowed the Federal Reserve to make direct loans of up to five years in term to established businesses, even outside of crisis situations. Under the Industrial Advances Act, some $280 million was made available for lending to businesses large and small. It was an amount equivalent to almost $1 trillion today in terms of an equivalent fraction of U.S. GDP.
Compared to lending under 13(3), this alternative provision allowed for far larger activity. Nearly two-thousand such loans were made through 1935 alone; some as small as $3,000 were funded by the regional Federal Reserve banks. After 1935, 13(b) loan production fell before surging higher once again during the Second World War. If such direct lending to businesses by the Federal Reserve seems unfamiliar today it is because Section 13(b) of the Federal Reserve Act was repealed in 1958 when legislation was passed attempting to make small business lending more appealing for private investment firms.
Panic of 2008
The absence of a major financial crisis meant that 13(3) went unneeded for decades. Though use of 13(3) was considered three times during the 1970s, during bailouts of the automaker Chrysler and the City of New York as well as amidst the failure of the Penn Central Railroad, invocation of the provision was ultimately foregone. Despite the extent of its existing powers sitting dormant, the FDIC Improvement Act of 1991 expanded once again the power of the Federal Reserve to lend to non-banks and widened the list of eligible collateral. That legislation, among the legacies of the Savings and Loan Crisis then unwinding, allowed the Fed to lend against collateral that would not have been accepted at the Fed’s ‘discount window’ under normal circumstances.
Section 13(3) took on greater significance during the subsequent financial crisis, from 2007-2009. The provision was used to extend a loan to JPMorgan Chase in connection with its acquisition of rival investment bank Bear Stearns. The Federal Reserve used 13(3) first to extend a bridge loan and then to purchase some of Bear Stearns’s troubled assets. Section 13(3) was also invoked to lend over $125 billion directly to AIG across multiple transactions and to provide guarantees to Citigroup and Bank of America. In each of these cases the Federal Reserve insisted that the borrowers were unable to obtain credit elsewhere and that the extension of credit was needed to arrest, and hopefully reverse, the panic.
Besides rescuing particular firms, Section 13(3) was also used during the crisis to create the Primary Dealer Credit Facility, which provided securities dealers with financing for their inventory, and the Term Asset-Backed Securities Loan Facility (TALF) which provided longer term financing to holders of asset-backed securities. Just these two programs had almost a cumulative $200 billion extended at their respective peaks and neither was the largest of that era, that being the Term Securities Lending Facility. In aggregate, Fed lending under Section 13(3) peaked at $710 billion in November 2008 before being repaid in full, even earning the Fed, and therefore the Treasury, a profit of over $30 billion.
Though the Federal Reserve’s use of its powers during the crisis have largely been regarded as effective, even if individual programs may have been less impactful than anticipated, its powers under 13(3) have since been curtailed. This was done under the Dodd-Frank Act just as the economy began its slow recovery.
The legislation made impossible the kinds of bailouts the Fed initiated. No longer could the central bank make loans to single entities as it had to AIG and in connection with the acquisition of Bear Stearns by JP Morgan Chase. Dodd-Frank added the clause “for any participant in any program or facility with broad-based eligibility” to the text of 13(3), thus barring aid to specific firms. Overall, the law reflected a shift, prioritizing the ability to orderly restructure or liquidate financial firms as an alternative to rescues. Dodd-Frank also required the consent of the Treasury in establishing programs under 13(3).
Despite the need for consent, a roll-out of 13(3) programs was initiated again in 2020. Some 2008-era programs were revived, including the Primary Dealer Credit Facility and TALF. However, even new programs were also established to purchase corporate bonds, again under the authority granted by Section 13(3). Not only was Treasury approval forthcoming but $50 billion was committed by the Treasury to protect the Federal Reserve against losses should any arise from certain of these programs. As with the crisis a decade earlier, the interventions were regarded as successful in their aims, even if some wondered whether broad programs were truly much less of a bailout than individual rescue packages.
Though the powers it granted have been somewhat curtailed, Section 13(3) of the Federal Reserve Act still augments the Federal Reserve’s already substantial role in America’s financial system. As fairly recent events have illustrated yet again, it is often the central bank that is poised to react quickest to changing financial circumstances and hence why the initiative continues to lie with it in formulating a response. So significant has the provision been that few can claim to understand the Federal Reserve, or at least its powers in responding to crises, without being familiar with Section 13(3). Understanding its history wouldn’t hurt either.
More from the Tontine Coffee-House
Learn more about the financial panic that led to the establishment of the Federal Reserve. Also read of the Fed’s role in American exchange rate policy in the 20th century.
1. Fettig, David. “Lender of More Than Last Resort.” Federal Reserve Bank of Minneapolis, 1 Dec. 2002.
2. Fettig, David. “The History of a Powerful Paragraph.” Federal Reserve Bank of Minneapolis, 1 June 2008.
3. Johnson, Christian A. “From Fire Hose to Garden Hose: Section 13(3) of the Federal Reserve Act.” Loyola University Chicago Law Journal, vol. 50, 17 June 2019, pp. 715–742.
4. Labonte, Marc. “Federal Reserve: Emergency Lending.” Congressional Research Service, 27 Mar. 2020.
5. Sastry, Parinitha. “The Political Origins of Section 13(3) of the Federal Reserve Act.” FRBNY Economic Policy Review, Sept. 2018.