The Fed and investment banks, - Wallison

Since the Bear Stearns bailout, most commentators in the US have assumed that the Federal Reserve’s action would eventually result in Fed regulation of investment banks – a superFed, as some have called it. But it was always assumed that this would occur through legislative action, as Congress considered whether to place the resources of the US government behind the investment banking industry, as those resources have been placed behind commercial banks. However, on Monday, with the support of the Treasury, the Securities and Exchange Commission and the Fed signed a memorandum of understanding that, in effect, puts the key elements of a Fed regulatory structure – and implicit Fed backing for the large investment banks – into place. What this amounts to is a straightforward Fed reach for important new regulatory authority, an unprecedented step in which a weak SEC – chastened after the failure of Bear Stearns – has been complicit. It would be perfectly acceptable if the agreement covered only the emergency period the markets are now experiencing, but it has no time limit. The agreement is very bad news for US taxpayers. Fed involvement with the regulation of investment banks will introduce moral hazard into the securities business for the first time and pave the way for a vast new US government liability. The agreement between the Fed and the SEC will seriously compromise market discipline, which only exists when creditors and other counterparties believe that they are financially at risk. What now amounts to ongoing supervision of the financial condition of investment banks by the Fed sends an unmistakable signal to the markets that the government believes itself to be at risk. Under these circumstances, investors will be justified in believing that the US government will ultimately stand behind the large investment banks. This will irretrievably compromise market discipline, which in turn will produce the very risk-taking and subsequent losses that regulation – as recently as the savings and loan debacle – has never been able to prevent. The key question arising out of the Bear Stearns bailout is whether the surrounding crisis was a unique event, or just the first of many similar crises resulting from a secular change in the market itself. If we are to make significant changes in policy, there should be substantial evidence that the financial market is materially different today than it has been in the past. But there is little evidence of this. In mid-March, when the bailout occurred, the financial markets were on the edge of chaos. This was – and in many respects still is – an unprecedented event. In the 70 years since the Depression, there has never been a crisis that the Fed could not address simply by flooding the market with liquidity. This crisis, however, was not a case of one institution’s insolvency causing others to become temporarily illiquid; this was a case where the financial stability of virtually all the world’s largest financial institutions was simultaneously in question. Ultimately, the Fed had to take credit risk on to its own balance sheet in order to stem the panic. In short, this unprecedented event should not be the basis for a major change in regulatory policy unless there is evidence that it will routinely recur in the future. One reason frequently cited for viewing today’s market as different is the advent of the credit default swap. These seemingly mysterious derivatives are said to make the market more “interconnected”, so that the failure of a large investment bank might cause a systemic collapse. This is not correct. A CDS is like insurance or a performance bond; it moves risks by contract from one place to another, but does not create risks that did not already exist. Thus, even if a Bear Stearns failure had triggered obligations from those who had written CDS protection against a Bear default, the counterparties who were covered by this protection would have been relieved of a loss they would otherwise have suffered. The total amount of risk in the market is the same; it is just held by different institutions. To be sure, the unwinding in the Bear Stearns case would have been complicated, but that is a reason to set up a clearing house for swaps, not to regulate investment banks. Moreover, unlike commercial banks, investment banks are unlikely candidates ever to cause systemic risk. Investment banks collateralise their borrowings. If they fail, their creditors can usually sell the collateral to make themselves whole. In contrast, the failure of a large commercial bank leaves its depositors and other creditors without funds until it is resolved. That is why large commercial banks, which have open account obligations to thousands of other banks, creditors and counterparties, can be said to be too big to fail. Applying the too-big-to-fail label to investment banks reflects a serious misunderstanding of how their business model differs from that of a commercial bank.In order to sign their agreement, the Fed and the SEC had to ignore a request by two powerful senators – Christopher Dodd and Richard Shelby, the chairman and ranking member of the Senate banking committee – who asked the two agencies in a letter last week to respect the prerogative of Congress to assign responsibilities to regulatory agencies. Instead, the two agencies have created a fait accompli that takes the question out of the hands of Congress. If Congress wants to have anything important to say about the regulation of the financial markets and the liabilities to be borne by the taxpayers, it should step in now to nullify this agreement or limit it to the emergency lending programme the Fed began in March.