Banks Can Now Use Deposits to Fund Investment Banking Operations?

Reader Michael M called our attention to this statement in a Financial Times article:

The Fed also suspended rules that prohibit banks from using deposits to fund their investment banking subsidiaries.

Was this the quid pro quo for Band of America buying Merrill? If so, the repercussions extend beyond BofA. This is a time when the federal authorities need to be vigilant, not lax about banks taking risk with depostors’ funds.

Note than many banking experts, post the S&L crisis and now, recommend the reverse, “narrow banking”, which requires banks to invest depositors’ funds only in the very safest assets. This is the exact opposite of the sort of regulatory measures needed to improve the health of the banking system. Expediency trumps soundness.

Any reader inputs appreciated.

Print Friendly, PDF & Email


  1. Anonymous

    No more rules/regulation.

    This is what happens in a Ponzi scheme when the perpertrator is the government. They get to keep playing the Ponzi scheme even AFTER it has unravelled.

    What do they care? It’s not their money being placed in jeopardy.

    I’m sure they’ve all got their Swiss bank accounts set up by now…

  2. Anonymous

    I’m not an expert on this but using deposits to fund investment banking activities — when we know investment banks own a ton of garbage — sound a bit scary, doesn’t it?

  3. Peripheral Visionary

    Yves, I strongly suspect that this is to give investment banks another source of financing even as the repo market could be coming under stress. Many of the repo lenders may end up stuck with collateral from Lehman repos, and those who lent to Lehman on questionable collateral, like non-Agency MBS and equities, will be in trouble. As such, liquidity is disappearing quickly; this move is designed to provide a stopgap source of funding to make up for a potential tightening in the repo market.

    The message of the Fed press release is very direct: the Fed is extremely concerned over a potential deleveraging in the repo market and is expanding its own facilities and loosening the rules (some might say breaking the law) to compensate.

    Of course, the overall effect will be that the risk for the investment bank is reduced but the risk for the commercial/retail bank goes up. The FDIC can’t be happy, but I’m not sure they were consulted.

  4. Terry

    What’s to worry about? FDIC will pick up the tab for the first $100K of depositors when the bank goes belly up.

    Now, the question is: Will FDIC raise the premium all banks pay to cover the expected higher FDIC payouts because of more bankruptcies…or will FDIC turn to Congress to re-build its fund?

    You know where my money is.

  5. dd

    Bloomberg confirms:
    "The Fed also granted an exemption on a rule that limits banks' transactions with their brokerage subsidiaries, a move that provides securities dealers with another source of funding if they need it for market making this week."

    Article also explains tri-party repo:
    "Changes to the Fed collateral for securities dealers will make it closely match “collateral that can be pledged in the tri-party repo systems.'' Banks use tri-party repos, or repurchases, for short-term financing amongst each other.
    In effect, the Fed is assuring that if investors pull away from brokers, they will be able to access cash through the PDCF with the same wide set of collateral used in tri-party repo, including stocks."

  6. Don Pagach

    This really seems like a bad idea from the get-go. Its one thing to lose investors and creditors funds but if a bank takes out a big chunk of depositor funds confidence could be incredibly damaged. It appears that loss of confidence is the last thing needed today. Maybe what they are trying to do is get someone to buy WAMU for all of the deposits, which is really the only asset that the company has…
    P.S. Thanks for all of the hard work that you have done on this story especially over the last week.

  7. pd130

    If don pagach’s conjecture is right, that would really be backing up over the body.

    Unfortunately, WaMu is such a big takedown that he just might be right.

  8. Matt Dubuque

    Hi Yves-

    Hope you are well.

    As with all Fed moves, the exact and precise language used is paramount. The Fed never uses words like “misunderestimate” or other gibberish that spews from the mouth of other actors very influential in policymaking.

    The key word here is “suspend”. It did not say “eliminate”.

    All the difference in the world.

    I’m a vigorous and emphatic advocate of DRAMATICALLY increased oversight of these children who were playing with WEAPONS of MASS DESTRUCTION and will cause thousands excess deaths in the USA (in all likelihood) with their irresponsible and often criminal conduct.

    My quick and competent take on the Fed’s careful use of the word “suspend” in this policy move is that the objective here is to do EVERYTHING humanly possible to assist us in a hard landing, rather than a crash landing.

    We are attempting to land a jumbo jet filled with our loved ones in a hurricane that is just barely a Category 3. It is not a Category 5 hurricane (and let’s hope it doesn’t become one) but attempting a hard landing in such a turbulent environment, surrounded by microbursts, is exceptionally dangerous. ONLY the outstanding pilots of Southwest Airlines should be trusted to attempt it.

    We may not make it. Anyone who has landed in a severe thunderstorm in Houston or Atlanta knows the mathematics and the turbulence of which I speak. We are in a Class 4 rapids, as whitewater rafters would say.

    During the descent, as we attempt a dangerous hard landing, we don’t want to lose a wing on the airplane. Then we all die.

    As such, the Fed has temporarily SUSPENDED this rule during the hard, forced landing with an air traffic control system dismembered by Saint Reagan.

    If we make it (and Geithner deserves to be Treasury Secretary or the new Fed chief if we do), I can assure you that the Fed is going to take the engineers of the plane with inferior rivets and send them to Guantanamo Bay for interrogation and punishment that Donald Rumsfeld insists would be completely legal.

    The rule is only suspended. We need to hope a hard landing is possible.

    The rule will return.

    Here’s to a hard landing.

    Enjoy your day. Mine will be dominated by my entry into San Francisco film society. I can’t wait!
    It’s been a long time coming and I’ve been very patient.

    My real love is film. I’ve just felt a duty to be a Paul Revere of sorts, because I am aware of things in the markets and about the Fed that others are not. I apologize for my previous stridency.

    It was midnight and I, like Paul Revere in a sense, had to be sufficiently loud and abrasive so as to wake people up.

    That need has now passed.

    Matt Dubuque

  9. Adam

    Right on Matt…

    I’ve become one of those tinfoil hat commentators at NYT. Posting and emailing writers about the subprime/altA/Frannies/CDO/Deflation/Hyperinflation risk for months now.

    Maybe it was a waste of time, or maybe a few smaller investors increased cash holdings.

    I don’t think our work is over though. Both McCain and Obama (and of course Hillary) are all severely compromised by the financial services industry. (Bam took 600k from Goldman alone)

    The only way we’re going to get systemic reform that limits the ability of these firms to damage the larger economy (which will negatively impact their profitability) is if we have a Take America Back campaign in the 2012 election. Maybe we’ll get the hard landing and by then things will be back to normal. But if it’s a crash the survivors will out for blood.

  10. S

    LAraence Lindsey talking this am about Fed expansing its balance sheet and buying $50 billion of mortgages. The binary outcome comes closer

  11. Yves Smith

    Matt D,

    Neither I or anyone it the preceding comments used the words “eliminate” or “minsuderestimate”. You have a tendency to imply that I or readers said things they did not say in an effort to make yourself look better by distorting what other said to put them down. I have little tolerance for that. Any more of this and I will start moderating comments, and ones like the one above do not make the grade. I’ve had other bloggers look at your posts and they have encouraged me to put you on a very short leash.

    One of the draws of this blog isn’t just what I write, it is also that I have a high quality comment stream.
    People are courteous for the most part, thoughtful, colorful, and the questions are intelligent. This is an asset I intend to protect.

    Second, per the TAF, which is supposedly a temporary facility, there is no reason to believe it will be easy to roll this suspension back.

    Third, it is pure speculation on your part the that Fed will increase supervision. You accuse others of sloppy use of language and then immediately segue to assertions with no factual backup.

    Moreover,even if the Fed were to increase supervision, Henry Kaufman and others have pointed out that the bank regulators lack the capabilites to monitor risk. For instance, we’ve written repeatedly about how Value at Risk, the main risk metric used by the Fed and other central banks, is woefully inadequate.

  12. Anonymous

    that’s under the assumption that they were not doing it all along. I really think that is just a green light to do it. These banks were and have been doing this all along. The just were given authority to continue the practice.


  13. S


    Comment on the way you see the equity side playing out. Are we to belive this was a firewall to stop a negative liquidiation feedback loop in euqity or a backstop to the repo markets should the collateral find no home?

    Also, what about redemptions for hedge funsds. Creditsights saying there is $150B of LEH debt and sr. unsecured likley to get 60-80 cents.

    So has the Fed put in place a facility for hedge funds as well? I know it was menbtioned for key financial players but left unclear?

  14. Anonymous

    OMG. I may be an economics novice, but I recall a report by Nightline's Robert Krulwich that this was a HUGE problem with Japan's banking crisis in the late 90's. Their banks had lost all of their money, and had become "zombie banks." They had lost their capital account & were essentially dead, but they continued to make riskier deals to rebuild their capital account, but with the depositors' money instead of their own! They were gambling with money that wasn't their own in the hopes of making a big score.

    Now I'm REALLY scared.

  15. Anonymous

    um, from the fed… – “an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board”

    hmmmm, where have we heard this before, i wonder?

  16. David Merkel

    Not too surprising. The Fed loosened regulations allowing banks to lend to their broker-dealer affiliates with reduced capital requirements, when BAC bought CFC… this is just another bad step down the road, and I’m sure the Fed thinks that they will reverse these changes when things normalize. Sigh, when will they learn… my guess is that they won’t. You can’t teach a Sneech.

  17. doc holiday

    Almost a year ago, I came here hoping to warn people about pension fund risks and the fraud associated with hedge funds being able to gain access to pension accounts. Along the way, no one ever responded, other than to say I was off topic, or that I was a troll, a spammer, and in addition, journalists at WSJ and The Post ignored my email pleas to do in depth stories on underwriters and hedge funds that were being granted exemptions to use pensions like casino chips. The Department Of Labor, among other departments in our government, like FTC, SEC, DOJ. FBI are all failing Americans today by continuing to allow The Bush Coup and wall street to abuse power. Once again, where is Congress?

    It’s an old sermon of mine here, but when banks are ready to play with all your deposits, in order to gamble and party even harder, maybe that lack of safety and increased risk will hit closer to home?

  18. Anonymous

    The airplane analogy is apt. Here is another on one:

    This plane loaded with first class business passengers – and the everyday taxpayer, is headed straight into a mountain. Only, their instruments say the mountain isn’t there. The co-pilot, the treasury, has his parachute on and is saying “I’m outta here”. The pilot must must pull up before he can think of finding even a hard place to land.

    This whole mess is pretty much due to “pilot error”. The Fed and Treasury have made one blunder after another. This weekend’s “risk event” has been predicted for months. Instead of acting to turn this situation around before another crises hits, the Fed and Treasury have opted to sit and wait for the next crises only to then panic and ultimately to make another blunder.

    If the risk is systemic collapse, the Congress, Fed and Treasury need a systemic solution.

  19. dh

    Re, anon @ 11:10

    Interesting topic, here is an FYI:

    Among the most important tools that U.S. bank regulators have to protect the safety and soundness of U.S. banks are the legal restrictions that limit the ability of a bank to lend to affiliates. Section 23A of the Federal Reserve Act provides that a bank may not lend more than 10 percent of its capital to any one affiliate or more than 20 percent of its capital to all affiliates combined. Of equal importance, any loan to an affiliate must be either fully collateralized by cash or U.S. Treasury securities or overcollateralized by other assets in an amount of 10 to 30 percent, depending on the type of asset or instrument used to secure the loan. Section 23A also prohibits the purchase of low-quality assets by a U.S. bank from its affiliates. Section 23B of the Federal Reserve Act requires that all transactions between a bank and its affiliates be conducted only on an arms-length basis. These restrictions are designed to limit the ability of an owner of a bank to exploit the bank for the benefit of the rest of the organization.

    Hmmm, yes, interesting:

    See also: Dear Mr. Huffstutler: (June 7, 2005

    This is in response to the request by Bank of America Corporation (“BofA”), Charlotte, North Carolina, for an exemption from section 23A of the Federal Reserve Act and the Board’s Regulation W for transactions in which Bank of America, N.A. (“Bank”) borrows securities from U.S. broker-dealer subsidiaries of BofA (“Affiliated Broker-Dealers”).

  20. Blissex

    Thanks for the various 23A comments, which show that section has been honored more in the breach for “too big to fail” preferred customers.

    The irony is that currently in effect it is “too big to fail” corporations that regulate the Fed*mart, and it is the Fed*mart that has to deposit reserves with them :-).

    An article mentioned in another blog:

    makes the point that currently the Fed and therefore the Treasury are providing margin lending on stocks (and try to imagine banks presenting Lehman stock at the Fed window…).

    But margin lending is likely what has fed the stupendous bubbles that have happened in the past dozen years:

    and as I mentioned previously (probably) this seems to have been caused by the effective nullification of reserve requirements in 1995:
    «The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was
    effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or “broad
    money” with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let’s look at the facts.

    I guess some people will remember that M3 is no longer reported by the Fed. Coincidentally of course.

  21. Guruprasad

    Investment Banking in US is nothing but a crap. Folks don’t seem to have common sense while they trade in Subprime. Just imagine buyer doesn’t know the identity of the borrower but willing to buy the mortgage which clearly lacked common sense ( I mean it). Investment banks normally run for ruining money, by the ruined and it sole aim is to ruin the economy thereby ruins the life of common people and create damage for whole country.

    Fed is going to suffer for its crimes. I expect CITI is going to be high profile banking collapse that could happen and would signal the bottom of US markets. Just note the date of my writing. You’d remember it once CITI got collapsed.Bcoz CITI would obviously make more use of this deal. U know what Citi would do. It would never sleep to swallow the money.
    If Bank deposits are allowed to run investment banks, I’d ask US people to deposit their money in Public Sector banks of India, where your investments are safe and secure (It’s not an advertisement. Its truth). Or as an alternative US depositors should find some other country (Country which they trust and sound in economy)and deposit their money in those banks which are by far safest bet.

  22. Alan

    This IS the exact opposite of what needs to be done. It is a continuation of “muddle through” as a strategy for dealing with the financial sector collapse. Borrow more and hope for the best.

    Kind of a reverse Glass-Steagall. We’re on the march to two megabanks, or three if you count Citigroup on life support.

    There is no stability until the structure is the Glass-Steagall structure with commercial banks totally outside the sway of investment houses.

    Does anybody know what happens with the Lehman toxic paper on the Fed’s balance sheet? At what point is the Fed stuck?

  23. Aaron Krowne

    I think your read is correct, Yves.

    This is an extension of the Fed’s one-off 23A exemption policy, begun last August. They seem to have turned it into a blanket decree.

    Rather than overtly suspending reserve requirements, they simply stated that “collateral” must be provided to the commercial banking arm — but we all know what /that/ means.

    The upshot is they are indeed allowing the system to become even more highly leveraged, as if that will solve the problem. The assumption here is still that the problem is a short-term matter of liquidity, and that increasing leverage will not simply exacerbate the problems.

    They will be wrong.

    The end-game of the collapse just got that much more spectacular.

  24. Blissex

    «Kind of a reverse Glass-Steagall.»

    Oh it is even better — we are now in a situation where in effect:

    * Large banks are regulating Fed activities.

    * The Fed has increasing requirements to deposit significant reserves with large banks.

    * This is to done to prevent an excessive contraction of credit, if the Fed were free not to deposit new funds with the large banks.

    * Large deposit taking institutions are *required* to buy investment banks (the G-S reverse).

    * The SEC mandates relaxed accounting standards in the stockmarket.

    «a continuation of “muddle through” as a strategy»

    You forget there is an important election pending. Any substantive action might be interpreted as helping one or the other campaign, so everything has to be frozen until November or January.

    Actually even the lack of intervention is helping one of the campaigns — a cleanup now would destroy the republican claims to good economic management.

    The strategy seems to be that the race is close enough that the RNC and the business interests that fund them want to see who wins in November. If it is Obama, probably depression and catastrophe before January, if it is McCain, bailouts and inflation.

  25. Yves Smith

    blissex and aaron.

    Thanks for your confirmation and further insights, but man, this is making me ill.

    It would be hard, in general term,s to devise a worse course of action: increasing leverage and by reducing the segregation of depositary subs, increasing the internal links in a system that is already too tightly coupled. These measures only increase the risk and cost of disaster (if were weren’t already in one).

  26. Anonymous

    blissex, I think too much mismanagement by Wall Street & Washington have guaranteed that the next president will inherit a bouncing baby depression.

  27. Cash Mundy

    (Editor’s Note: Mr Mundy is so far in the money that it has gone to his head and he has taken to referring to himself in the Third Person, and may buy himself a cult or two. We hope this is only a temporary aberration.)

    Cash wants to set the record straight on one thing: if the financials were on a rafting trip (you know, one of those team-building corporate field-trips), it would be in Class V (Eastern Scale) water at floodstage. Y’all might have seen Deliverance? Ol’ Cash happens to have run the Chattooga a time or two, and in this case, last night the Guide fell out of the raft at Entrance to the Five Falls, today the raft went into Corkscrew and flipped, and now everyone is in the water swimming towards such famous drownin’ machines as Crack In The Rock and Sock’em Dog. Hank, Ben and Tim are on river left with throw-bags, except that in their excitement they forgot you are supposed to hold onto the rope and throw the bag, and they are just hurling everything including their PFDs and Tevas into the river, possibly in a not entirely senseless attempt to partially slake the gluttonous lust of Earl the River God and his Dread Double-Recirculators so that maybe at least one of the swimmers makes it. Just so you know.

    But the 7-dimensional chimera who’s 3+1-space world-line signature is referred to as “Cash” feels that y’all should know that what has actually happened is that when LEH imploded, so much liquidity concentrating in one place and then disappearing could only indicate one thing… Yes, you guessed it: those whackjobs protesting the LHC had the right idea, but they were lysdexic; it was actually LEH that would start the Mother of All Black Holes. Already you can barely see AIG and WM, they are so close to the event-horizon, and while BAC heroically tried to pull MER out, it just pulled itself further into the accretion disc, where it is spinning along with GS, MS and the rest. Remember Cash‘s pardner H. Ross Perot and his Giant Suckin’ Sound? Now there’s a light-show to go with it, mostly in the X-ray spectrum.

    The long and short of it is, we’re all Doomed; in fact, in the long run, we’re all Dead. But in the meantime, Cash is taking care of some business and would like to buy a suitable cult, ideology unimportant, serious inquiries only. He stashed some money in an International Bond Fund today, and also has a good supply of shiny glass beads in reserve.

  28. Francois

    “The upshot is they are indeed allowing the system to become even more highly leveraged, as if that will solve the problem. The assumption here is still that the problem is a short-term matter of liquidity, and that increasing leverage will not simply exacerbate the problems.

    They will be wrong.

    The end-game of the collapse just got that much more spectacular.”

    I’ll assume that Fed and Treasury officials know full well how risky the path taken can be.

    Which begs the question: Why do it regardless?

    I mean, I can understand that a financial crash would have disastrous consequences for the world economy but this push-n’-pray approach is like going all in in a Texas Hold’em tournament with a 4-7 unsuited hand.

    Is the financial sector THAT short stacked?

Comments are closed.