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January/February 1994, 
Vol. 76, No. 1
Posted 1994-01-01

Federal Reserve Lending to Banks That Failed: Implications for the Bank Insurance Fund

During the 1980s, many banks failed, imposing large losses on the Bank Insurance Fund (BIF). The Federal Reserve loaned to many of the banks that ultimately failed, an association that convinced many that Federal Reserve lending practices had increased BIF losses. Based on this concern, Congress imposed limits on Federal Reserve lending to troubled banks in the Federal Deposit Insurance Corporation Improvement Act of 1991. R. Alton Gilbert investigates whether evidence supports the conclusion that Federal Reserve lending practices increased BIF losses. For example, among banks that failed in 1985-90, BIF losses were larger at banks that borrowed from the Fed in their last year of operation. Other evidence, however, does not support the view that the lending by the Fed caused the higher loss rate among the borrowers. Although borrowers remained open slightly longer than nonborrowers with ratings indicating imminent danger of failure, the behavior of borrowers during their last year is consistent with relatively effective actions of supervisors in limiting the risk they assumed. In addition, declines in large-denomination deposits, which increase the cost to the BIF of resolving bank failure cases through liquidation, declined at about the same rate for both borrowers and nonborrowers in their last year.