The New York Times Dealbook writes today about Citadel founder Ken Griffin and his views on Wall Street… here are some of his proposed solutions… sounds good…
~~~~ ” First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.
But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.” ~~~~
~~~~ “It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.
That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.
“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.
Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)” ~~~~
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Bernanke Says Fed `Stands Ready’ to Boost Cash Loans to Banks
By Craig Torres and Steve Matthews
May 13 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke said financial markets remain unsettled and the central bank will increase its auctions of cash to banks as needed.
While market conditions have improved, they remain “far from normal,” Bernanke said today in the text of a speech to an Atlanta Fed conference at Sea Island, Georgia. “We stand ready to increase the size of the auctions if further warranted by financial developments.”
Bernanke’s comments contrast with those by Treasury Secretary Henry Paulson and Wall Street leaders including Vikram Pandit, chief executive officer of Citigroup Inc., who say the worst of the credit crisis is over. The Fed chief said it will take “some time” for financial firms to resolve the crisis by raising new capital and strengthening their management of risk.
The flight from risk since August has made financial institutions reluctant to lend to each other, driving up banks’ borrowing costs. The central bank has made its own balance sheet available to both banks and bond dealers through three new lending tools, and an expansion of existing programs.
Bernanke said the Fed’s efforts have yielded “some improvement,” while also noting that the steps raise questions regarding moral hazard, or protecting those who take on risk.
The central bank’s extension of the federal safety net raised questions about whether the government should now use taxpayer money to stem mortgage foreclosures, the primary cause of market distress.
`Moral Hazard’
“A central bank that is too quick to act as a liquidity provider of last resort risks inducing moral hazard,” Bernanke said. The belief that the Fed is always standing by would give “financial institutions and their creditors less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.”
Bernanke didn’t discuss the path of interest rates or the outlook for the economy. The Federal Open Market Committee last month cut its benchmark rate by a quarter point to 2 percent and signaled it’s ready for a pause after seven reductions.
Cleveland Fed President Sandra Pianalto said in a speech in Paris today that consumer prices are rising faster than she’d like and that inflation is a “key risk” to the economic outlook. Pianalto is a voter on the FOMC this year.
The Fed chairman said federal banking agencies are trying to address moral hazard through a review of “policies and guidance regarding liquidity risk management to determine what improvements can be made.”
Raise Capital
“Future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing,” Bernanke said. “Ultimately, market participants themselves must address the fundamental sources of financial strains — through deleveraging, raising new capital, and improving risk management.”
That process will take time, he added, noting that “once financial conditions become more normal, the extraordinary provision by the Federal Reserve will no longer be needed.”
The Fed announced May 2 that it would boost the Term Auction Facility, or TAF, to $150 billion per month from $100 billion, the third increase since the program began in December.
Premiums in term dollar funding markets still “remain abnormally high,” Bernanke said. “Funding pressures have also been evident in the strong participation at recent TAF auctions even after the recent expansion in auction sizes.”
The gap between three-month Treasury bill yields and three- month dollar-denominated loans in London, narrowed to 89 basis points yesterday, the least since Feb. 20. A basis point is 0.01 percentage point.
Boosting Auctions
On March 11, the Fed announced the Term Securities Lending Facility, which allows primary dealers to swap up to $200 billion of AAA rated commercial and residential mortgage-backed securities and other collateral for the Fed’s holding of Treasury securities for up to 28 days. The facility was aimed at helping dealers finance mortgage bonds.
The FOMC expanded the facility May 2 to include AAA rated asset-backed securities. The decision followed two separate requests by groups of Senate and House members that the Fed accept debt backed by student loans under the program.
“The Federal Reserve has had to innovate in large part to achieve what other central banks have been able to effect through existing tools,” Bernanke said.
Bernanke also repeated his defense of the Fed’s rescue of Bear Stearns Cos. in March. The central bank invoked emergency authority on March 16 to start direct lending to government bond dealers, and arranged $30 billion in financing to facilitate the Bear Stearns takeover by JPMorgan Chase & Co.
Bear Stearns
“A bankruptcy filing would have forced Bear’s secured creditors and counterparties to liquidate the underlying collateral,” Bernanke said in his speech. “Given the illiquidity of markets, those creditors and counterparties might have sustained losses.”
The Bear Stearns loan has been criticized by some former officials and Fed watchers, who said the central bank shouldn’t substitute its own loans for fleeing creditors when institutions become insolvent.
Vincent Reinhart, former director of the Fed Board’s Division of Monetary Affairs, called the Bear rescue the “worst policy decision in a generation.”
Creditors also now perceive a wide safety net under investment banks, which the Fed doesn’t supervise.
The cost of default protection on Merrill Lynch & Co. debt fell to 1.58 percentage point yesterday from 3.3 percentage points March 14, CMA Datavision’s credit-default swap prices show.
Kansas City Fed President Thomas Hoenig said May 6 the central bank’s decisions are “likely to weaken market discipline.”
http://www.bloomberg.com/apps/news?pid=20601087&sid=afNmATbvHcUs&refer=home
Chairman Ben S. Bernanke
At the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Georgia (Via Satellite)
May 13, 2008
Liquidity Provision by the Federal Reserve
Well-functioning financial markets are an essential link in the transmission of monetary policy to the economy and a critical foundation for economic growth and stability. However, since August, severe financial strains have shaken this foundation. A sharp housing contraction has generated substantial losses on many mortgage-related assets and a broad-based tightening in credit availability. Consistent with its role as the nation’s central bank, the Federal Reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning.1
In my remarks today, I will begin by reviewing the principles that should guide central banks’ actions to support market liquidity. Then, in light of those principles, I will discuss the liquidity measures implemented by the Federal Reserve in response to the financial turmoil. I will conclude by offering some thoughts on liquidity regulation.
The Principles Behind Central Bank Liquidity Provisions
The notion that a central bank should provide liquidity to the banking system in a crisis has a long intellectual lineage. Walter Bagehot’s Lombard Street, published in 1873, remains one of the classic treatments of the role of the central bank in the management of financial crises. Bagehot noted that the basis of a successful credit system is confidence. In one passage, he writes, “Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? and is that confidence wise? These are the cardinal questions” (p. 11). He pointed out that confidence is particularly important in banking and in other situations in which the lender’s own liabilities are viewed as very liquid by its creditors. In such situations, as Bagehot put it, “…where the ‘liabilities,’ or promises to pay, are so large, and the time at which to pay them, if exacted, is so short,” borrowers must demonstrate “an instant capacity to meet engagements” (p. 11).
Meeting creditors’ demands for payment requires holding liquidity–cash, essentially, or close equivalents. But neither individual institutions, nor the private sector as a whole, can maintain enough cash on hand to meet a demand for liquidation of all, or even a substantial fraction of, short-term liabilities. Doing so would be both unprofitable and socially undesirable. It would be unprofitable because cash pays a lower return than other investments. And it would be socially undesirable, because an excessive preference for liquid assets reduces society’s ability to fund longer-term investments that carry a high return but cannot be liquidated quickly.
However, holding liquid assets that are only a fraction of short-term liabilities presents an obvious risk. If most or all creditors, for lack of confidence or some other reason, demand cash at the same time, a borrower that finances longer-term assets with liquid liabilities will not be able to meet the demand. It would be forced either to defer or suspend payments or to sell some of its less-liquid assets (presumably at steep discounts) to make the payments. Either option may lead to the failure of the borrower, so that the loss of confidence, even if not originally justified by fundamentals, will tend to be self-confirming. If the loss of confidence becomes more general, a broader crisis may ensue.
How should a central bank respond to a sharp increase in the demand for cash or equivalents by private creditors? Before talking about Bagehot’s answer, I should note that the Bank of England in his time was a hybrid institution–it was privately owned by shareholders, but it also had a public role. To fulfill its public role, the Bank of England did not in all cases maximize its profits; notably, it held a larger share of its assets in liquid form than did other banks, thereby foregoing some return. Nevertheless, in the context of the gold standard, the Bank’s stock of liquid assets was relatively modest in size, raising the possibility that even this quasi-public institution could run out of cash should the demand for liquidity become high enough.2 In this context, Bagehot’s advice on how the Bank of England should respond to a generalized liquidity shortage was somewhat counterintuitive. He wrote:
In opposition to what might be at first sight supposed, the best [policy] . . . to deal with a drain arising from internal discredit, is to lend freely. The first instinct of everyone is the contrary. There being a large demand on a fund which you want to preserve, the most obvious way to preserve it is to hoard it–to get in as much as you can, and to let nothing go out which you can help. But every banker knows that this is not the way to diminish discredit. This discredit means, ‘an opinion that you have not got any money,’ and to dissipate that opinion, you must, if possible, show that you have money: you must employ it for the public benefit in order that the public may know that you have it. The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times. (p. 24)
And what are the terms at which the central bank should lend freely? Bagehot argues that “these loans should only be made at a very high rate of interest” (p. 99). Some modern commentators have rationalized Bagehot’s dictum to lend at a high or “penalty” rate as a way to mitigate moral hazard–that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot’s principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England’s own finite store of liquid assets.3 Today, potential limitations on the central bank’s lending capacity are not nearly so pressing an issue as in Bagehot’s time, when the central bank’s ability to provide liquidity was far more tenuous.
Bagehot defined a financial crisis largely in terms of a banking panic–that is, a situation in which depositors rapidly and simultaneously attempt to withdraw funds from their bank accounts. In the 19th century, such panics were a lethal threat for banks that were financing long-term loans with demand deposits that could be called at any time. In modern financial systems, the combination of effective banking supervision and deposit insurance has substantially reduced the threat of retail deposit runs. Nonetheless, recent events demonstrate that liquidity risks are always present for institutions–banks and nonbanks alike–that finance illiquid assets with short-term liabilities.
For example, since August, mortgage lenders, commercial and investment banks, and structured investment vehicles have experienced great difficulty in rolling over commercial paper backed by subprime and other mortgages. More broadly, a loss of confidence in credit ratings led to a sharp contraction in the asset-backed commercial paper market as short-term investors withdrew their funds. And remarkably, some financial institutions have even experienced pressures in rolling over maturing repurchase agreements (repos). I say “remarkably” because, until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations. In March, rapidly unfolding events demonstrated that even repo markets could be severely disrupted when investors believe they might need to sell the underlying collateral in illiquid markets. Such forced asset sales can set up a particularly adverse dynamic, in which further substantial price declines fan investor concerns about counterparty credit risk, which then feed back in the form of intensifying funding pressures.
Recent research by Allen and Gale (2007) confirms that, in principle at least, “fire sales” forced by sharp increases in investors’ liquidity preference can drive asset prices below their fundamental value, at significant cost to the financial system and the economy. Their work underscores the basic logic in Bagehot’s prescription for crisis management: A central bank may be able to eliminate, or at least attenuate, adverse outcomes by making cash loans secured by borrowers’ illiquid but sound assets. Thus, borrowers can avoid selling securities into an illiquid market, and the potential for economic damage–arising, for example, from the unavailability of credit for productive purposes or the inefficient liquidation of long-term investments–is substantially reduced.
Liquidity Powers of Other Central Banks
This prescription for providing liquidity in a crisis is simple in theory, but, in practice, it can be far more complicated. For instance, how should the central bank distinguish between institutions whose liquidity pressures stem primarily from a breakdown in financial market functioning and those whose problems fundamentally derive from underlying concerns about their solvency? The answer, at times, is by no means straightforward. There are other complexities, too. Central banks provide liquidity through a variety of mechanisms, including open market operations and direct credit extension through standing lending facilities. The choice of tools in a crisis depends on the circumstances as well as on specific institutional factors.
The European Central Bank (ECB), for example, routinely conducts open market operations with a wide range of counterparties against a broad range of collateral. In recent months, in light of intense pressures in term funding markets, the ECB has provided relatively large quantities of reserves through longer-term open market operations. Extending this strategy, the ECB also introduced a new refinancing operation with a six-month maturity. The first of these was executed on April 2 and was well received. The Bank of England has followed a similar strategy, expanding their term open market operations and accepting a wider range of collateral. Very recently, the Bank of England also initiated a special liquidity facility that allows banks to swap high-quality mortgage-backed and other securities for U.K. Treasury bills.
Differences in legal and institutional structure have affected the methods used by various central banks to inject liquidity in their markets. In the United States, in ordinary circumstances only depository institutions have direct access to the discount window, and open market operations are conducted with just a small set of primary dealers against a narrow range of highly liquid collateral. In contrast, in jurisdictions with universal banking, the distinction between depository institutions and other types of financial institutions is much less relevant in defining access to central bank liquidity than is the case in the United States. Moreover, some central banks (such as the ECB) have greater flexibility than the Federal Reserve in the types of collateral they can accept in open market operations. As a result, some foreign central banks have been able to address the recent liquidity pressures within their existing frameworks without resorting to extraordinary measures. In contrast, the Federal Reserve has had to use methods it does not usually employ to address liquidity pressures across a number of markets and institutions. In effect, the Federal Reserve has had to innovate in large part to achieve what other central banks have been able to effect through existing tools.
The financial distress since August has also underscored the importance of international cooperation among central banks. For some time, central banks have recognized that managing crises involving large financial institutions operating across national borders and in multiple currencies can present difficult challenges. Funding pressures can easily arise in more than one currency and in more than one jurisdiction. In such cases, central banks may find it essential to work closely together. For just this reason, the Federal Reserve, the ECB, and the Swiss National Bank have established currency swap arrangements and have coordinated their provision of dollar liquidity to international financial institutions over recent months.
Federal Reserve Liquidity Operations
In the United States, open market operations have long been the principal tool used by the Federal Reserve to manage the aggregate level of reserves in the banking system and thereby control the federal funds rate. The discount window has typically functioned as a backstop, serving as a source of reserves when conditions in the federal funds market tighten significantly or when individual depository institutions experience short-term funding pressures. Throughout much of the Federal Reserve’s history, this basic structure has proven adequate to address liquidity pressures, even during some periods of market turmoil.
However, it became abundantly clear that this traditional framework for liquidity provision was not up to addressing the recent strains in short-term funding markets. In particular, the efficacy of the discount window has been limited by the reluctance of depository institutions to use the window as a source of funding. The “stigma” associated with the discount window, which if anything intensifies during periods of crisis, arises primarily from banks’ concerns that market participants will draw adverse inferences about their financial condition if their borrowing from the Federal Reserve were to become known.
The Federal Reserve has taken steps to make discount window borrowing through the regular primary credit program more attractive. Most notably, we narrowed the spread of the primary credit rate over the target federal funds rate from 100 basis points in August to only 25 basis points today. In addition, to address the pressures in term funding markets, we now permit depositories to borrow for as long as 90 days, renewable at their discretion so long as they remain in sound financial condition. These actions have had some success in increasing depository institutions’ willingness to borrow. Moreover, the existence of the option to borrow through the discount window, even if not exercised, likely has improved confidence by assuring depository institutions that backstop liquidity will be available should they need it.
Still, the continuing disruptions in short-term funding markets over recent months suggested that new ways of providing liquidity were necessary. Last December, the Federal Reserve introduced the Term Auction Facility, or TAF, through which predetermined amounts of discount window credit are auctioned every two weeks to eligible borrowers for terms of 28 days. In effect, TAF auctions are very similar to open market operations, but conducted with depository institutions rather than primary dealers and against a much broader range of collateral than is accepted in standard open market operations. The TAF, apparently because of its competitive auction format and the certainty that a large amount of credit would be made available, appears to have overcome the stigma problem to a significant degree. Indeed, a large number of banks–ranging from 52 to more than 90–have participated in each of the 11 auctions held thus far. The TAF has also simplified the implementation of monetary policy by providing greater predictability of the level of borrowings by depository institutions and consequently of bank reserves. The size of individual TAF auctions has been raised over time from $20 billion at the inception of the program to $75 billion in the auctions this month. We stand ready to increase the size of the auctions further if warranted by financial developments.
The recent market turmoil has also affected the liquidity positions of financial institutions that do not ordinarily have access to the discount window. In particular, prior to the recent experience, it was believed that primary dealers were not especially susceptible to runs by their creditors. Primary dealers typically rely on short-term secured financing arrangements, and the collateralization of those borrowings was thought sufficient to maintain the confidence of investors. Consequently, dealers’ liquidity management policies and contingency plans were typically based on the assumption that they would not be faced with a sudden loss of financing.
But these beliefs were predicated on the assumption that financial markets would always be reasonably liquid. As I have already noted, recent events have proven that assumption unwarranted, and the risk developed that liquidity pressures might force dealers to sell assets into already illiquid markets. This might have resulted in Allen and Gale’s fire sale scenario that I mentioned earlier, in which a cascade of failures and liquidations sharply depresses asset prices, with adverse financial and economic implications.
This heightened risk led the Federal Reserve to expand its ability to supply liquidity to primary dealers. In March, to ease strains that had developed in the agency mortgage-backed securities market, the Federal Reserve initiated as part of its open-market operations a series of single-tranche repurchase transactions with terms of roughly 28 days and cumulating to up to $100 billion. For the purposes of these transactions, primary dealers can deliver as collateral any securities eligible in conventional open market operations. Additionally, the Federal Reserve introduced the Term Securities Lending Facility (TSLF), which allows primary dealers to exchange less-liquid securities for Treasury securities for terms of 28 days at an auction-determined fee. Recently, the Federal Reserve expanded the list of securities eligible for such transactions to include all AAA/Aaa-rated asset-backed securities.
By mid-March, however, the pressures in short-term financing markets intensified, and market participants were speculating about the financial condition of Bear Stearns, a prominent investment bank. On March 13, Bear advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated, and that it would be forced to file for bankruptcy the next day unless alternative sources of funds became available. A bankruptcy filing would have forced Bear’s secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued. In such circumstances, the Federal Reserve Board judged that it was appropriate to use its emergency lending authorities under the Federal Reserve Act to avoid a disorderly closure of Bear. Accordingly, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide short-term funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed the company’s financial obligations. The Federal Reserve, again in close consultation with the Treasury Department, agreed to supply term funding, secured by $30 billion in Bear Stearns assets, to facilitate the purchase.
In a further effort to short-circuit a possible downward spiral in financing markets, the Federal Reserve used its emergency authorities to create the Primary Dealer Credit Facility (PDCF). The PDCF allows primary dealers to borrow at the same rate at which depository institutions can access the discount window, with the borrowings able to be secured by a broad range of investment-grade securities. In effect, the PDCF provides primary dealers with a liquidity backstop similar to the discount window for depository institutions in generally sound financial condition.
To date, our liquidity measures appear to have contributed to some improvement in financing markets. The existence of the PDCF seems to have bolstered confidence among primary dealers’ counterparties (including the clearing banks, which provide the dealers with critical intra-day secured credit). In addition, conditions in the Treasury repo market, which became very strained around mid-March, have improved substantially. Liquidity is better in several other markets as well. For example, spreads on agency mortgage-backed securities have dropped in recent weeks after reaching very high levels in mid-March, as have spreads between conforming fixed-rate mortgage rates and Treasury rates. Spreads on jumbo mortgage loans have retraced a portion of their earlier large increases, but recent regulatory and legislative changes make it difficult to assess the impact of liquidity measures in that segment of the market. Corporate debt spreads have also declined somewhat from recent highs.
These are welcome signs, of course, but at this stage conditions in financial markets are still far from normal. A number of securitization markets remain moribund, risk spreads–although off their recent peaks–generally remain quite elevated, and pressures in short-term funding markets persist. Spreads of term dollar Libor over comparable-maturity overnight index swap rates have receded some from their recent peaks but remain abnormally high.4 Funding pressures have also been evident in the strong participation at recent TAF auctions even after the recent expansions in auction sizes, and, of late, depository institutions have borrowed significant amounts under the primary credit program for terms of up to 90 days.
Ultimately, market participants themselves must address the fundamental sources of financial strains–through deleveraging, raising new capital, and improving risk management–and this process is likely to take some time. The Federal Reserve’s various liquidity measures should help facilitate that process indirectly by boosting investor confidence and by reducing the risks of severe disruption during the period of adjustment. Once financial conditions become more normal, the extraordinary provision of liquidity by the Federal Reserve will no longer be needed. As Bagehot would surely advise, under normal conditions financial institutions should look to private counterparties and not central banks as a source of ongoing funding.
Liquidity Regulation and Moral Hazard
The provision of liquidity by a central bank can help mitigate a financial crisis. However, central banks face a tradeoff when deciding to provide extraordinary liquidity support. A central bank that is too quick to act as liquidity provider of last resort risks inducing moral hazard; specifically, if market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors would have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.
Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot’s advice: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times” (p. 24). Indeed, under the international Basel II capital accord, supervisors are expected to require that institutions have adequate processes in place to measure and manage risk, importantly including liquidity risk. In light of the recent experience, and following the recommendations of the President’s Working Group on Financial Markets (2008), the Federal Reserve and other supervisors are reviewing their policies and guidance regarding liquidity risk management to determine what improvements can be made. In particular, future liquidity planning will have to take into account the possibility of a sudden loss of substantial amounts of secured financing. Of course, even the most carefully crafted regulations cannot ensure that liquidity crises will not happen again. But, if moral hazard is effectively mitigated, and if financial institutions and investors draw appropriate lessons from the recent experience about the need for strong liquidity risk management practices, the frequency and severity of future crises should be significantly reduced.
References
Allen, Franklin, and Douglas Gale (2007). Understanding Financial Crises, Clarendon Lectures in Finance. Oxford: Oxford University Press.
Bagehot, Walter (1873). Lombard Street: A Description of the Money Market. London: King. Reprint, Gloucester, U.K.: Dodo Press, 2006.
Clapham, John (1945). The Bank of England: A History. Cambridge, U.K.: Cambridge University Press.
President’s Working Group on Financial Markets (2008). “Policy Statement on Financial Market Developments (1.36 MB PDF),” March.
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Footnotes
1. Primary securities dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Fed’s Open Market Desk engages in the trades on behalf of the Federal Reserve System to implement monetary policy. Return to text
2. Such a circumstance could arise in two ways: The banking reserve–that is, the liquid assets backing deposits at the Bank of England–could fall to a low level as a result of heavy discounting or the issue reserve–that is gold bullion backing Bank of England notes–could run short because of substantial redemptions by note holders. Indeed, the Bank of England’s gold reserves, its ultimate store of liquidity, along with the gold in circulation, were quite small relative to total sterling deposits in the U.K. banking system. This implied, as English historian Sir John Clapham (1945) noted, that there was just a “thin film of gold” (p. 299) tying the pound to the gold standard. Return to text
3. A high rate, Bagehot (1873) wrote, “will prevent the greatest number of applications by persons who do not require it” (p. 99) and ensure that “no one may borrow out of idle precaution without paying well for it; that the [Bank of England’s] reserve may be protected as far as possible” (p. 99). Moreover, as Clapham (1945) observed, higher interest rates during a period of crisis would draw in gold from abroad, easing strains on the Bank. Return to text
4. Libor is the London interbank offered rate, a standard measure of the cost of funds in the interbank market. Return to text
http://www.federalreserve.gov/newsevents/speech/bernanke20080513.htm
New York watchdog wants derivative controls
By Aline van Duyn, Joanna Chung and Saskia Scholtes in New York
Published: May 12 2008 22:39 | Last updated: May 12 2008 22:39
Parts of the largely unregulated $62,000bn credit derivatives market may have to be subject to the kind of tighter controls that at present govern the insurance industry, New York’s insurance regulator said on Monday.
Eric Dinallo, the New York insurance superintendent, said that when derivatives contracts are bought to protect against defaults on actual bonds and loans – through instruments called credit default swaps – it may make sense to regulate them as if they were insurance products.
CDS provide a kind of insurance against the default of a company or particular security. Investors often use such contracts to bet on the creditworthiness of companies or securities without owning the underlying bonds, but they are also used by investors as a hedge for their cash positions.
There have been growing fears after the collapse of investment bank Bear Stearns that problems among some counterparties could create broader systemic risk.
Mr Dinallo said the potential for billions of dollars of losses incurred on CDS by insurer AIG and bond insurers, such as MBIA and Ambac, highlighted the need for a discussion about whether parts of the CDS market should be regulated.
American International Group, the giant insurer, took a $9.1bn writedown last week on the market value of swaps it had sold to insure investors against defaulting debt and said actual losses could be $1.25bn.
“There are two kinds of CDS,” Mr Dinallo told the Financial Times. “As much as 20 per cent of the CDS market consists of protection bought against bonds that are owned, and this could be considered a type of insurance. The rest of the market is used to place bets and is not based around hedging actual positions.”
Regulation would mean that entities providing this type of credit insurance would come under the oversight of insurance regulators such as Mr Dinallo and would have to allocate capital to their credit derivatives businesses.
However, Greg Zerzan, counsel and head of global public policy at the International Swaps and Derivatives Association, said banks active in the credit derivatives market already come under a host of other regulations.
“It is important to remember that dealers in these markets are highly regulated institutions, whose derivatives books are subject to capital requirements and scrutiny,” he said.
“Credit derivatives differ in important ways from insurance, including the fact that the holder need not suffer a loss in order for a payment to be made.” Insurance regulators have in the past determined that CDS should not be regulated as insurance.However, Mr Dinallo said this referred only to the CDS contracts used to place short positions on the direction of the credit market, so-called ”naked CDS”.
The notional value of CDS contracts has soared to $62,000bn from less than $1,000bn at the end of 2001. The rapid growth of the market has already led to concerns among regulators that middle and back offices have struggled to keep pace and provide the infrastructure the market needs, resulting in a backlog of unconfirmed trades and potential systemic risks if the market faces a large default.
http://www.ft.com/cms/s/0/301b99f0-205d-11dd-80b4-000077b07658.html
US investment banks need insolvency mechanism-FDIC
Fri May 16, 2008 2:47pm ED
By John Poirier
WASHINGTON, May 16 (Reuters) - If another troubled U.S. investment bank spirals toward insolvency, the federal government should have in place a mechanism to shut it down, the head of the Federal Deposit Insurance Corp said on Friday.
Some of the existing regulatory framework for commercial banks should also apply to investment banks, such as similar leverage standards, increased supervision, and corrective actions for undercapitalized institutions, said FDIC Chairman Sheila Bair.
“There should be a mechanism for the government to close the bank down in an orderly way,” Bair said at a Brookings Institution event where the think tank released recommendations to improve regulation of the U.S. financial services industry.
“Trying to homogenize standards of leverage would be extremely helpful,” Bair said. “There are some parts of the banking regulatory framework that could very well be applied to investment banks.”
The March collapse of Bear Stearns Cos Inc (BSC.N: Quote, Profile, Research) and its emergency bail-out by the Federal Reserve has prompted lawmakers and regulators to take a closer look at the government’s oversight of investment banks.
The Securities and Exchange Commission currently monitors investment banks Morgan Stanley (MS.N: Quote, Profile, Research), Lehman Brothers (LEH.N: Quote, Profile, Research), Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research), Goldman Sachs Group (GS.N: Quote, Profile, Research) and Bear Stearns as part of its consolidated supervised entities program.
SEC Chairman Christopher Cox said earlier this month that the agency will require more disclosure of capital and liquidity of the investment banks that it supervises. The agency is also working with the Federal Reserve to lay out how the two entities will work together to oversee the investment banks.
The Brookings Institution recommended on Friday that the Fed be given authority to create a bridge bank to take control of a troubled investment bank that may be near bankruptcy. That would give regulators time to determine a least-cost solution and whether a piecemeal sale of the institution is necessary.
The FDIC has the authority to establish a temporary bridge bank of that nature if a commercial bank is in trouble, Bair said.
The Brookings report also recommended that regulators better supervise capital, liquidity and risk management at investment banks.
The FDIC insures deposits and some retirement accounts at commercial banks. (Reporting by John Poirier; Editing by Andrea Ricci)
http://www.reuters.com/article/marketsNews/idINN1641442520080516?rpc=44&pageNumber=2&virtualBrandChannel=0&sp=true
Banks Hide $35 Billion in Writedowns From Income, Filings Show
By Yalman Onaran
May 19 (Bloomberg) — Banks and securities firms, reeling from record losses resulting from the collapse of the mortgage securities market, are failing to acknowledge in their income statements at least $35 billion of additional writedowns included in their balance sheets, regulatory filings show.
Citigroup Inc. subtracted $2 billion from equity for the declining value of home-loan bonds in its quarterly report to the Securities and Exchange Commission on May 2 without mentioning the deduction in the earnings statement or conference call with investors that followed. ING Groep NV placed 3.6 billion euros ($5.6 billion) of negative valuations in its capital account, while disclosing only an 80 million-euro depletion to income.
The balance-sheet adjustments are in addition to $344 billion of writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised $263 billion from sovereign wealth funds, their own governments and public investors to shore up capital. The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the $35 billion leaves the banks with a $116 billion mountain of losses to climb.
“The smart people are the ones who’ve identified the problems, put them out there in full transparency, and addressed them by raising more capital,” said Michael Holland, who oversees more than $4 billion as chairman of Holland & Co. in New York. “There is still billions of dollars of crap out there that hasn’t worked itself through the system. Banks need more capital to work that all out.”
Accounting Rules
Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren’t considered permanent.
Banks that are more willing to acknowledge their balance- sheet writedowns, such as Amsterdam-based ING, say the valuations of assets will be reversed when markets recover. ING, the biggest Dutch financial-services company, said in its first-quarter earnings report last week that the drop in the value of bonds tied to home loans that are held to maturity is irrelevant as long as the underlying mortgages don’t default.
With that logic, most of the writedowns on the income statements could be reversed if asset prices recover. While some declines in valuations may reverse, most of the losses are permanent impairments caused by surging defaults on U.S. mortgages, said Janet Tavakoli, author of “Collateralized Debt Obligations & Structured Finance,” published in 2004 by John Wiley & Sons Inc.
`Value Loss’
“Of course we can’t tell how much of a bank’s portfolio may actually be good stuff that will pay back at maturity,” Tavakoli said. “But there’s tremendous value loss that’s fundamental, not just due to credit market gyrations.”
Keeping those markdowns off income statements just delays the realization of the losses, according to Brad Hintz, a New York- based analyst at Sanford C. Bernstein & Co.
“The banks that have taken advantage of this accounting approach are going to have a price to pay later,” said Hintz, the third-highest ranked securities analyst in an Institutional Investor magazine survey. “You don’t avoid the price. Those that have taken it all in their income statements will come out with clean balance sheets and move on.”
Reminiscent of Japan
Ignoring bad debt and postponing inevitable losses was one of the main reasons behind Japan’s decade-long economic slump that began in the 1990s, said Boston University law professor Charles Whitehead.
Faced with new capital requirements and a weakened ability to meet them, Japanese banks deferred the recognition of their losses, aided by regulators who refrained from implementing the rules, Whitehead wrote in a 2006 paper published in the Michigan Journal of International Law.
“U.S. regulators may be tempted to go soft on banks too,” said Whitehead, who teaches securities regulation, in an interview. “The new capital rules already rely significantly on self-modeling by the banks. So if anything, the risks may be greater in the U.S. today than they were in Japan in the 1990s.”
The new bank-capital regime, known as Basel II, has gone into effect in some European countries and is being implemented in the U.S. and others starting this year. It allows financial institutions to use in-house risk models instead of just relying on external credit-worthiness ratings in calculating their risk- weighted capital requirements.
The largest U.S. securities firms have been under capital requirements shaped by Basel II since 2004.
Shareholders at Stake
Even if regulators are soft on banks and brokers when it comes to capital requirements, investors won’t be, according to Samuel Hayes, professor emeritus at Harvard Business School in Boston.
The collapse in March of New York-based Bear Stearns Cos., once the fifth-largest U.S. securities firm, shows that fulfilling regulatory capital requirements isn’t sufficient to survive, Hayes said. The SEC has said Bear Stearns was “well-capitalized” until the moment it faced bankruptcy as clients and creditors lost confidence and withdrew their money.
“They have to keep raising capital levels, there’s no getting around that fact,” Hayes said. “Perception is so important here. If investors or creditors feel a bank doesn’t have a strong capital cushion to face further writedowns, that could prove problematic.”
Balance-Sheet Items
A review of the balance sheets and regulatory filings of more than 50 banks showed that 20 of them chose to keep some subprime- related losses off their income statements. The marks were recorded instead on balance-sheet items labeled “other comprehensive income” or “revaluation reserves.”
Seattle-based Washington Mutual Inc., which has taken $217 million of subprime-related writedowns against profits, kept a bigger amount on the other-comprehensive-income line of its balance sheet, which swung to a $782 million loss in the first quarter. Fortis, the Amsterdam and Brussels-based bank, put 990 million euros of losses in revaluation reserves, in addition to the 3.3 billion euros it reported on its income statement.
Merrill Lynch & Co. in New York, which has booked $31.7 billion from market markdowns in its income statements, is keeping another $5.3 billion of losses on its balance sheet as other comprehensive income. The revaluation reserve reduction of 740 million pounds ($1.4 billion) at London-based Lloyds TSB Group Plc is bigger than the 667 million pounds charged against profit.
Officials at Citigroup, Merrill Lynch, Washington Mutual and Fortis declined to comment. Lloyds TSB spokeswoman Kirsty Clay said none of the assets included in the available-for-sale reserves are considered to be “permanently impaired.”
$100 Billion Hole
The writedowns aren’t finished yet. London-based Fitch Ratings Ltd. expects as much as $110 billion in additional losses on subprime securities.
Declines in asset prices have spread beyond subprime though, affecting other mortgage bonds, securitized car and student loans, leveraged lending that backs private equity buyouts and credit derivatives. When all that is included, the IMF estimates that total losses from the U.S. subprime debacle will reach $1 trillion, of which $510 billion will be born by banks. That means some $130 billion in losses remains to be taken.
“The $100 billion hole between writedowns and capital raised so far needs to be filled,” said Michael Mayo, a New York-based analyst who tracks the financial-services industry at Deutsche Bank AG. “If you don’t fill that hole, with the 20-to-1 leverage existing on average out there, you need to de-lever $2 trillion of assets. You can do that or raise more capital.”
One way to increase capital has been to halt or slow down the pace of share buybacks. Companies often repurchase stock to offset dilution that occurs when shares are distributed to employees as part of their compensation.
Looking for Capital
Citigroup, the biggest U.S. bank by assets, JPMorgan Chase & Co., the third-largest bank, and Morgan Stanley, the No. 2 U.S. securities firm by market value, have suspended stock-buyback programs. All the companies are based in New York.
Outstanding stock increased 7 percent at Citigroup, 4.3 percent at Morgan Stanley, and 2 percent at JPMorgan during the past two quarters, according to regulatory filings. New York-based Lehman Brothers Holdings Inc., the fourth-biggest securities firm, has done the same without announcing a suspension of its repurchase program. Lehman shares in circulation rose 4.3 percent.
The first place banks and brokers went looking for capital was in the deep pockets of the Asian and Middle Eastern sovereign wealth funds, flush with cash from rising commodity prices. Then they reached out to public investors, who were offered hybrid securities with characteristics of both equity and debt, limiting their dilutive impact on common shares.
`It’s Like Shampooing’
The sovereign funds, which bought shares at 20 percent above today’s market prices, are probably not coming back soon, said Jeffrey Rosenberg, a New York-based managing director at Bank of America Corp., who was among the first analysts to warn clients about the mortgage crisis.
Banks can’t keep selling hybrid bonds because ratings firms place limits on how much of their capital can be tied up in such securities. Rosenberg said the next round of equity-strengthening probably will be in the form of common stock.
“It’s like shampooing: lather, rinse, repeat — write down, raise capital, repeat,” Rosenberg said. “How long can they keep doing it? Shareholders are in for a long ride.”
The List
The following table lists 20 banks that have kept some of their writedowns on their balance sheets, along with the losses the banks have incurred in their income statements. All figures are in U.S. dollars, converted at the May 17 exchange rate if originally disclosed in another currency.
http://www.bloomberg.com/apps/news?pid=20601109&sid=ajTu.H_velzQ&refer=home
Black Mark
An accounting standard comes under the microscope.
Economist Staff
The Economist
May 19, 2008
THIS has been a crisis of firsts. The first major crisis of the securitisation era; the first big test of the European Central Bank; and the first crisis of “fair-value” accounting, the set of standards which requires institutions to mark many of their assets to market value. Many blame fair value for causing the credit crunch, arguing that it can cause a downward spiral in prices by encouraging institutions to sell assets quickly and forcing them to take write-downs that do not reflect the “true” value of the underlying assets.
“Fair value is a big mistake,” says the boss of one big European bank. AIG, an American insurer, has proposed a change to the rulebook so that companies and their auditors would put only their own estimates of maximum losses into the profit-and-loss account.
A lot of the criticism is pure cant. After all, mark-to-market gains were happily accepted by banks before the bubble burst. The regime’s more helpful rules are still being applied with gusto: for example, banks are able to reduce the fair value of their own debt issues if the credit spreads on them widen. Barclays, for one, recorded gains of £658m ($1.3 billion) on its own liabilities in fiscal 2007.
The fact that deciding on a fair value has been so tough reflects the complexity of the products as much as the state of the markets. Setting a price for derivatives that have been repeatedly repackaged, overcollateralised and subordinated is difficult in any conditions. “Four thousand pieces of a Porsche are more difficult to value than a Porsche itself and the sum of the parts does not equal the whole,” says Bill Michael of KPMG, an accountancy firm (choosing an appropriate car).
Some banks clearly also underestimated the risks of illiquidity. Industry insiders report that prudent institutions were running internal valuation models even when market prices were clearly observable: those that were not had to scramble to develop such models when markets seized up, causing delays in proper disclosure. Many banks failed to price the chances of illiquidity into the cost of internal funding for traders. And some institutions, bankers allege, were parking illiquid structured products in their trading books to attract a lower capital charge (regulators now plan to beef these charges up). That meant mark-to-market losses immediately showed up in their income statements.
The alternative to fair value — holding assets at historic cost — has few admirers. “Is it really better to keep losses and not to tell shareholders?” asks John Smith of the International Accounting Standards Board (IASB). It is striking that executives at American investment banks, which have long been subject to fair-value rules, largely accept the regime.
There are lessons to be learned. With marking to market, a wobble can quickly become a collapse, illiquidity makes prices harder to set and valuations are more susceptible to sentiment. That increased volatility needs to feature in executives’ and risk managers’ calculations.
Regulators also need to bear in mind that one of the central assumptions of the fair-value regime has not worked out quite as planned. If prices fall too far, as critics say they now have done, investors should be stepping in to buy the assets. But that is difficult when everyone is reducing their leverage. “Clients invariably say they would like to buy but they cannot because they own too much of it already or they own something else,” says Colm Kelleher, Morgan Stanley’s chief financial officer.
Moreover, fair-value accounting appears to play a part in the upswing of a cycle as well as in the downswing. Research by Tobias Adrian of the Federal Reserve Bank of New York and Hyun Song Shin of Princeton University indicates that banks take on more debt when the mark-to-market value of their assets increases. In other words, fair value did not just worsen the bust: it also fuelled the boom.
http://www.cfo.com/article.cfm/11397389
Senator from tiny state is making big waves
Rhode Island’s Jack Reed, budding Banking Committee heavyweight, is taking on regulators, questioning accounting standard convergence
By Nicholas Rummell
May 19, 2008
As Congress adds its two cents to efforts to reform the financial system, here’s a name corporate America would do well to learn, if it hasn’t already: Sen. Jack Reed.
The Rhode Island Democrat serves on both the Senate Appropriations Committee and the Senate Banking Committee, where he also chairs a subcommittee on securities and investments. It’s in this role that Mr. Reed is starting to make waves, taking on capital markets regulators over lax banking and accounting regulations, calling for a task force to investigate speculation in the commodities markets and raising concerns about efforts to converge U.S. and international accounting standards.
Mr. Reed is up for re-election for his third Senate term in November. But Rhode Island is a heavily Democratic state, and with no Republican opponent having emerged yet, his seat is considered relatively safe. And although his name has been tossed around for a possible administrative position under a Democratic president, he plans to stay where he is for now, according to his staffers.
While many of the banking-related pet projects on which Mr. Reed has focused are not exactly headline grabbers, they are certainly critical to the world of corporate finance.
“He’s really emerged as the expert” on accounting and banking issues in the Senate, said Dan Pedrotty, director of the office of investment at the AFL-CIO, who has met with Mr. Reed over concerns about proxy access, off-balance-sheet entities and other issues. “He’s always been vocal and active on the committee…but with the leadership role, he’s taken on a real advocacy position.”
That view is shared even by those on the other side of the ideological fence. “He’s fair and intellectually thorough and serious…even if we don’t agree on a particular issue,” said Scott DeFife, senior managing director of government affairs at the Securities Industry and Financial Markets Association. SIFMA executives have met with Mr. Reed and other lawmakers about a potential overhaul of capital markets regulation next year.
Mr. Reed has been particularly tough on the Securities and Exchange Commission and the Financial Accounting Standards Board for not doing enough to require adequate disclosure from banks that engaged in rampant securitization using off-balance-sheet entities during the past several years. Concerns that the true extent of the credit crisis has not yet been revealed as a result of such entities still pervade the market.
Accounting standards “were written as much to expedite securitization as to provide real disclosure to investors and a real sense of the overall responsibility for these investments,” Mr. Reed said in an interview. As complex mortgage-backed securities proliferated, the SEC and other regulators “were so enthralled with the architecture, they weren’t examining the plumbing.”
In February, Mr. Reed asked the SEC, FASB and the International Accounting Standards Board to address concerns about how off-balance-sheet entities are potentially being used to hide losses from investors. The responses, made public last week, show standard-setters realize current accounting rules need tweaking, but Mr. Reed wants to go further.
In its letter, FASB said the use of qualified special purpose entities (QSPEs)—off-balance-sheet structures that needn’t be consolidated by the primary beneficiary as others must now be—may have extended beyond the uses stated in company legal documents. The board also said it has questions about companies’ compliance with probability assessments used in estimating losses from securitization, the adequacy of company disclosures and other issues.
For his part, Mr. Reed seems happy with the voluminous FASB reply, but less so with the vaguer SEC response that “certain aspects of the accounting and disclosure requirements should receive immediate attention.” Mr. Reed may end up holding additional hearings this summer to focus on SEC disclosure regulations. “They have to be much more candid in terms of where they see the problems based upon the recent experience and propose solutions,” he said.
He may also initiate legislation in 2009 regarding how capital markets are regulated, including requiring additional oversight over investment banks, depending on what the agencies themselves do over the next few months.
In particular, Mr. Reed wants the SEC and the Fed to complete the memorandum of understanding they are working on to delineate responsibilities among the two regulators related to investment banks. “This is an area where it’s not quite clear where the line begins for the SEC and where the line stops for the Fed,” he said. “Ultimately, we’re going to have to decide [by legislation or SEC regulation] how we’re going to regulate these entities which now have access to the Federal Reserve.”
Although Mr. Reed has no formal background in banking or securities, he’s had time to become acquainted with many of the issues. After graduating from West Point, he served as a paratrooper and later a teacher at the military academy, before receiving a master’s in public policy and a law degree from Harvard. After serving three terms in the House, he was elected to the Senate in 1996. He later served on the Joint Economic Committee from 2001 to 2006.
Mr. Reed receives most of his campaign cash from lawyers (at least $392,000 so far, according to opensecrets.org) and securities firms (about $308,000). Among the top five contributors to his 2008 re-election campaign are Wall Street heavyweights J.P. Morgan Chase, Goldman Sachs and Bank of America.
Business associations give him a low ranking in terms of his voting record; he supported positions held by the U.S. Chamber of Commerce 30% to 40% of the time in the last few years, and voted in line with the interests of the National Association of Manufacturers 11% of the time in 2005 and 2006.
While fellow liberal Barney Frank deploys a caustic wit as chairman of the House Financial Services Committee, Mr. Reed often takes a soft-spoken approach with those he questions during oversight hearings and is roundly praised for meeting with various groups, even those that disagree vehemently with his positions.
“He has raised a lot of issues that need to be raised,” said Barbara Roper, director of investor protection at the Consumer Federation of America, who met with Mr. Reed earlier this year along with unions and state securities regulators. “He’s not out hunting for scalps. He has focused more on oversight rather than legislation.”
“I am glad to see someone asking the right questions with respect to what has occurred in the markets during the past year,” former SEC chief accountant Lynn Turner said in an e-mail. “Given that the FASB was first asked by the SEC back in the late [1980s] to fix the accounting for SPEs and didn’t get it done…it would seem pretty clear that greater oversight on the part of millions of affected investors by someone is really needed.”
Mr. Reed is potentially setting himself up as a key opponent to some of the ideas the Treasury Department espoused in the regulatory blueprint it released earlier this year. That blueprint—which likely won’t result in major changes this year, but sets the stage for an overhaul in 2009 or later—suggested a more principles-based regulatory system, modeled on the United Kingdom’s model.
But Mr. Reed thinks such a “prudential” system may not be the best approach, since it lacks rules that can be enforced. As he sees it, the push for a principles-based system is another step in financial deregulation, which while it began before the Bush Administration, has accelerated under it and may be responsible for some of the problems afflicting the credit markets.
“That debate I think has been part of this administration since the beginning,” Mr. Reed said. “So we have eight years now…[and] this is what the financial markets see.”
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080519/REG/230878277
Fed should not be super-regulator -U.S. senator
Mon May 19, 2008 5:56pm ED
WASHINGTON, May 19 (Reuters) - The Federal Reserve should not be made into the United States’ super-regulator under an anticipated shake-up of how the country’s banks are governed, a senior Republican lawmaker said on Monday.
“I think, myself, that we should not give the Fed all the regulatory power,” Sen. Richard Shelby, the top Republican on the Senate Banking Committee, told CNBC.
“They have a lot of power now. They are our central bank and they are also our biggest bank regulator and they have other powers. The SEC has got their role,” he said.
The Securities and Exchange Commission oversees investment banks Morgan Stanley (MS.N: Quote, Profile, Research), Lehman Brothers Holdings (LEH.N: Quote, Profile, Research), Merrill Lynch (MER.N: Quote, Profile, Research), Goldman Sachs (GS.N: Quote, Profile, Research) and Bear Stearns (BSC.N: Quote, Profile, Research) for liquidity and capital levels.
But the Fed has allowed these firms access to its discount window, normally reserved for commercial banks, which it does regulate and for whom it is the lender of last resort.
The Fed took this emergency measure after Bear Stearns’ liquidity nearly evaporated in March. The action was intended to stop financial markets from seizing up amid panic over huge subprime mortgage market losses, which has subsequently prompted calls to modernize the laws governing U.S. financial services.
The U.S. Treasury has published a hefty plan on how to go about overhauling the country’s regulatory framework, including a suggestion to turn the Fed into a financial market stability policeman. It also discussed consolidating the number of regulators, which would mean the Fed surrendering some of its supervision duties of state and local banks.
The Fed has called the plan a good first step, in a diplomatic nod to the lengthy negotiations that lie ahead for any new banking rules. Lawmakers are also focused on the presidential and congressional elections in November and it is unlikely that any changes will be made before next year.
Fed insiders say they cannot monitor market stability without oversight of investment banks, which are currently regulated by the SEC. Shelby saw things differently.
“Now they (Fed) are going to have oversight. The SEC is going to have closer oversight,” he said. “We on the banking committees in the House and the Senate have got to do it because we do have a financial crisis.” (Reporting by Rachelle Younglai and Alister Bull; Editing by Leslie Adler)
http://www.reuters.com/article/marketsNews/idINN1951986320080519?rpc=44
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