Bear Stearns Consequences

The idea of the Fed taking protective custody of big investment banks has already led to arguments that those firms should be subject to the same capital requirements faced by the commercial banks already in the Fed's care. Worse, whatever flaws exist in current imperfect bank regulations would infect more of the financial system. Capital requirements inspired some commercial banks to mask some of their most toxic assets in "off-balance-sheet" instruments. Investment banks might be inspired to do the same, making their true financial health even murkier. Today's capital requirements also have the perverse effect of encouraging banks to shed capital when times are good and raise it just when they need it most, says Michael Peterson, research director at Pzena Investment Management, which owns shares of both flavors of bank. Thus, they are forced to sell assets in falling markets, while diluting their already beleaguered shareholders by issuing fresh equity and paying usurious interest rates for preferred stock and debt. This is what economists call "pro-cyclicality," a fancy way of saying it makes bad situations worse, possibly raising the likelihood that there will be more Bear Stearnses in the future. This is an extreme example, but it is worth remembering that the 1989 law passed to bail out the savings-and-loan industry pushed hundreds of thrifts to an early grave by raising their capital requirements when it was hardest to raise money. That law also created the Resolution Trust Corporation to dispose of the assets of defunct thrifts. The RTC became a greenhouse for bundling together risky assets into securities, which worked for a while, until the subprime disaster that just visited Wall Street. This isn't to suggest there should be no regulation. On the contrary, smarter regulation probably could have averted the mess we're in today. Rather, it's a reminder of the minefields policy makers face as they consider a post-Bear Stearns world.