Preparing For The Inevitable Government Bailout Of Financial Institutions.

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Includes: AIG, BAC, BLK, DB, JPM, MS, UBS
by: Kurt Dew

Summary

William Dudley, New York Fed Chief, takes a newly controversial position, saying the Fed's lender-of-last-resort function remains essential.

This article connects the necessity of rescue to a second necessity.

The banks must be profitable to be worthy of rescue.

Come on and rescue me

Come on baby and rescue me

-- Aretha Franklin

A regulator who is focused on the need for a plan in crisis

A practical eyes-wide-open member of the Federal Reserve's policy-making body, the Federal Open Market Committee (FOMC), is William Dudley, president of the Federal Reserve Bank of New York, the sole Reserve Bank President who is not rotated off the committee annually. As a Reserve Bank President, he is appointed by the New York Fed's Board of Directors (excluding bankers), not by the President of the United States. Further, as President of the New York Fed, he has substantial responsibility for the relationship between the Fed and Wall Street.

The Lender of Last Resort

Dudley's concern, expressed in a February 1, 2016 speech, is a component of the Dodd-Frank Act that reduces the ability of the Fed to bail out banks trapped in a liquidity squeeze. As Dudley points out, the Fed was created in part to be the "lender of last resort" to the banking system. That includes two responsibilities, providing access to the Fed's discount window in standard banking operations -- an important comfort to the bank's investors, who themselves have confidence in the bank but are concerned about other investors' fears.

The second, in Dudley's words:

…is to prevent the fire sale of assets by firms facing a sudden loss of funding from spreading contagion across the system and disrupting the provision of credit to the economy. This is particularly important during a financial panic, when the demand for liquidity increases sharply. Only the central bank has the ability to meet this increased demand under any potential circumstances.

His focus on the need for the Fed to focus on the Fed's mission is strangely controversial, in the reactionary post-Dodd-Frank world.

Dudley continues to point out a concern to which I refer in an earlier, third installment of a discussion of the role of bank regulators in the next financial crisis. Financial intermediation doesn't end at the door of the banks. And he provides a welcome endorsement of this notion: If the point of "lender of last resort" is to forestall a liquidity crisis, the Fed's responsibilities cannot end at the banks' door either.

Here I part company with Dudley, out of practical concerns. Dudley argues reasonably for a quid pro quo from non-banks needing rescue. If non-banks expect a rescue, they must meet the Fed's prudential requirements as well, he says.

But while this principle seems a classic rights/responsibilities, or cost/benefit trade-off, there are two objections:

  1. It is not possible for the Fed to have sufficient foresight: to have the ability to identify the source of the liquidity problem in advance asks too much. Certainly we have observed that problem in the past: Long Term Credit and AIG (NYSE:AIG) come to mind.
  2. Application of prudential standards to non-banks produces a whack-a-mole effect. Pressure placed on one institution simply moves risk-taking activities to another. The shadow banks were an example of risk-shifting leading to the Crisis.

What will really happen?

As in the Crisis, with the edifying exception of Lehman Brothers, and as in the past crises that I have mentioned in earlier posts, the regulators intervene.

It is important to point out the distinction between regulatory provision of funds, in whatever form, and the bailouts that characterized the response of European regulators to this same Crisis. Provision of funds is a legitimate function of government -- the equivalent of fiscal policy on a micro-level -- when those funds are repaid with appropriate interest. A bailout leads to government dependence.

Here is the subtle reason why it is important to achieve a balance between profitability and prudential regulation of financial institutions in the pre-crisis period. Without robust business lines, fueled by constant change and creative innovation which requires that sufficient capital to be poured into profitability -- and put at risk in the process -- all the prudential liquid assets in the world, there to prevent putative crises, will simply be government funds poured back and forth from the Fed to the banks.

This process of undue regulatory-inspired conservatism leads inevitably to two consequences:

  1. The banks die a slow, unprofitable death of the sort that has begun in the past year. We have witnessed this throughout the banking system both on a long-term secular basis begun over 40 years ago; and on a shorter-term basis more recently, as the dealer banks, especially Morgan Stanley (NYSE:MS) and UBS (NYSE:UBS); and to a lesser degree, the more diversified JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Bank of America (NYSE:BAC); and finally out of absolute desperation in the case of Deutsche Bank (NYSE:DB) and Credit Suisse (VTX:CSGN). It is no coincidence that these banks' health is directly related to the speed and decisiveness with which they jumped out of fixed income, currency and commodities (FICC) trading.
  2. The risk transfer that is the banks' function is passed to non-banks that to date are unfettered by regulation and can take the risks and create the profits -- institutions such as BlackRock (NYSE:BLK) and Citadel (Private.) If the Fed is looking for a new batch of non-bank regulated entities, these two might be a place to start.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.