Tuesday, September 16, 2008

Fed allows deposits to fund investment banking operations

(Naked Capitalism) One of the emergency measures implemented [yesterday] by the Fed was the suspension of the rules prohibiting banks from using deposits to fund their investment banking subsidiaries.

{Was this the quid pro quo for Band of America buying Merrill? If so, the repercussions extend beyond BofA. Note than many banking experts, post the S&L crisis and now, recommend the reverse, "narrow banking", which requires banks to invest depositors' funds only in the very safest assets. This is the exact opposite of the sort of regulatory measures needed to improve the health of the banking system. Expediency trumps soundness.}

From a speech by the Fed's Scott Alvarez:
Among the most important tools that U.S. bank regulators have to protect the safety and soundness of U.S. banks are the legal restrictions that limit the ability of a bank to lend to affiliates. Section 23A of the Federal Reserve Act provides that a bank may not lend more than 10 percent of its capital to any one affiliate or more than 20 percent of its capital to all affiliates combined. Of equal importance, any loan to an affiliate must be either fully collateralized by cash or U.S. Treasury securities or overcollateralized by other assets in an amount of 10 to 30 percent, depending on the type of asset or instrument used to secure the loan. Section 23A also prohibits the purchase of low-quality assets by a U.S. bank from its affiliates. Section 23B of the Federal Reserve Act requires that all transactions between a bank and its affiliates be conducted only on an arms-length basis. These restrictions are designed to limit the ability of an owner of a bank to exploit the bank for the benefit of the rest of the organization.
We received an e-mail today from a former bank regulator on this topic:
I worked as a senior supervisory analyst at the Federal Home Loan Bank of New York in the late 80s/ early 90s when the FHLB (and later the Office of Thrift Supervision) were cleaning up the S&L mess. In reading of this development, I am speechless. The whole point of our job was to minimize risk to the deposit insurance funds, and our bosses really drummed that one into our heads.

Regulators are supposed to be boring, bureaucratic, and, yes, make life difficult for those who would risk depositors' money inappropriately. I know that whole ethos is considered uncool at the moment, but no one can deny that the regulators did clean up the S&L mess in the end. Of course they should have been more proactive earlier on but when the crisis hit the regulators enforced proper discipline (some said too much so, I know).

The Fed seems to be enabling the very things it should be standing against. If he felt that Treasury needed to subsidize the Merrill takeover Paulson should have asked Congress for explicit appropriations of finite funds. The 23A suspension will make it hard for us to know how much is being risked, at what odds, and for how long. It is a blank check issued under the table.

All too often both bankers and regulators get overconfident during economic booms. However, if the regulators can't tighten the ship even during a crisis like this one we are lost.

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