I-Banks Can’t Have their Cake and their Discount Window Too

| About: Financial Select (XLF)

Hank Paulson is calling for increased regulation of Investment Banks if they’re going to be allowed to receive loans from the Fed in a financial pinch, but stopped short of calling for regulation on par with commercial banks.

From the NY Times:

Treasury Secretary Henry M. Paulson Jr. said on Wednesday that Wall Street investment firms must provide more information about their financial condition if they are occasionally allowed to borrow money from the Federal Reserve as commercial banks do. But he did not call for investment banks to be regulated in the same manner that commercial banks now are…

… Mr. Paulson defended the Fed’s recent offering of a $30 billion credit line to JPMorgan Chase to help it take over the foundering Bear Stearns investment bank — an arrangement that leaders of the Senate Finance Committee said on Wednesday they would investigate — but he said such moves ought not to become routine.

“The Federal Reserve acted promptly to resolve the Bear Stearns situation and avoid a disorderly wind-down,” Mr. Paulson said at the United States Chamber of Commerce’s annual Capital Markets Summit. “It is the job of regulators to come together to address times such as this, and we did so.”

Mr. Paulson acknowledged that the Fed’s decision to lend to investment banks creates a contradiction between how commercial and investment banks are being treated, and he implied that investment banks ought to be subject to the “same type of regulation.”

But moments later, he said: “Recent market conditions are an exception from the norm. At this time, the Federal Reserve’s recent action should be viewed as a precedent only for unusual periods of turmoil…”

… Mr. Paulson said that “any regular access to the discount window” should involve “the same type of regulation and supervision” to which commercial banks are subject.

But Mr. Paulson said in effect that investment banks should not count on regular access to the window. “Despite the fundamental changes in our financial system, it would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed’s liquidity facility,” he said.

But that’s just it, is it not? Banking regulations are designed to prevent banking failures and to mitigate the impact a badly run bank can have on the economy and the public at large, especially during times of turmoil. Things like the FDIC and access to the Fed’s liquidity facilities are intended to be the benefits of submitting to regulations, not to mention the added benefit of potentially protecting an institution from itself.

I think that the I-Banks can’t have it both ways: weak regulation when times are good and access to the Fed Discount Window/commercial bank benefits when times are bad. The idea that the Bear Stearns situation should only be considered a precedent for turbulent times is somewhat irrelevant, as the goal of banking regulations should be to prevent things from getting that bad AND to mitigate the impact of a failing institution on the economy. If I-Banks are operating at a level where they can wreck significant financial damage on the larger economy, then it’s in the public’s interest that they’re subject to increased regulation in order to protect both the public and the institutions themselves. Especially if the impact on the economy and financial markets of a Bear Stearns collapse, would’ve been as catastrophic as many market watchers believe.

However I think the regulations placed on I-Banks should be “hybridized” as they’re not the same animal as a commercial bank; the goals of any new regulations should be to both protect the taxpayers from funding another BSC and to serve as an early warning system to future collapses. I-Banks should be subject to increased disclosure and potentially higher capitalization requirements, in exchange for access to the Fed’s discount window in times of market unrest and/or to prevent another Bear Stearns from happening. The key is striking balance between giving an I-bank discount window access when more liquidity make keep them from losing money, vs. when said access will prevent a collapse in the future.

The problem is determining that level of Fed assistance where an I-Bank is merely saved from falling into a Bear Stearns situation, as opposed to an I-bank receiving a de facto subsidy that makes a rough time smoother and enables them to generate more profits. I’m not interested in making life easier for the I-banks per se; I simply want to protect the tax payer from getting stuck with the $30 billion tab from another I-bank’s bad investment decisions.

When trying to determine the balance, the question offered is: Was there a level of Fed assistance where the tax payer could’ve loaned Bear Stearns $5-10 billion with a strong probability of getting paid during this past fall, vs. taking on $30 billion of risk with no guarantee of repayment last week?

Perhaps a more important question is: Will any new regulations truly come out of this? Are the politicians just rattling their sabers or are they working towards real change?


The NY Times: “Paulson Calls for More Oversight of Investment Banks” – David Stout, March 26, 2008.

Disclosure: at the time of publishing, the author didn’t own a position in any of the companies mentioned in this article.