A Former Regulator on the Fed Allowing Deposits to Fund Investment Banking Operations

Due to the lateness of the hour, I will be a bit more terse than I perhaps should be. We discussed yesterday that one of the emergency measures implemented by the Fed was the suspension of the rules prohibiting banks from using deposits to fund their investment banking subsidiaries. Reader dh helpfully pointed to background information at the Federal Reserve:

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.

We received an e-mail today from a former bank regulator on this topic:

I worked as a senior supervisory analyst at the Federal Home Loan Bank of New York in the late 80s/ early 90s when the FHLB (and later the Office of Thrift Supervision) were cleaning up the S&L mess. In reading of this development, I am speechless. The whole point of our job was to minimize risk to the deposit insurance funds, and our bosses really drummed that one into our heads.

Regulators are supposed to be boring, bureaucratic, and, yes, make life difficult for those who would risk depositors’ money inappropriately. I know that whole ethos is considered uncool at the moment, but no one can deny that the regulators did clean up the S&L mess in the end. Of course they should have been more proactive earlier on but when the crisis hit the regulators enforced proper discipline (some said too much so, I know).

The Fed seems to be enabling the very things it should be standing against. If he felt that Treasury needed to subsidize the Merrill takeover Paulson should have asked Congress for explicit appropriations of finite funds. The 23A suspension will make it hard for us to know how much is being risked, at what odds, and for how long. It is a blank check issued under the table.

All too often both bankers and regulators get overconfident during economic booms. However, if the regulators can’t tighten the ship even during a crisis like this one we are lost.

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  1. Max

    The 23A suspension will make it hard for us to know how much is being risked, at what odds, and for how long. It is a blank check issued under the table.

    The problem that the rule suspension creates is even more serious – basically, it leads to massive adverse selection, when the already suspicious interbank market completely shuts down due to the lack of what’s left of banking transparency.

  2. Kevin

    In other words this “emergency measure” may potentially allow the transfer of funds from the FDIC towards the funding of BoA’s purchase of Merrill Lynch? A rathre stealthy government bailout.

    It seems there really is a pretty fine line between a capitalism and communism.

  3. Richard Kline

    Thank you, Mr. Timewas Regulator, for clarifying our present situation: We are lost. To me, the idea of moving around these deposits, or of AIG sending assets up chain under dire pressure of insolvency, is madness beyond madness, the kind of panic funk move which implies that sensible thought is no longer possible by the actors involved.

  4. Rob

    agreed on all counts

    the loonies are running the asylum and i am frankly perplexed that the equity markets are still holding up

    these rules were created out of the ashes of the Great Depression — for unelected officials to be overriding them by fiat screams of chaos

  5. ScottH

    Capitalism is what you do when you have capital. Once you have eaten all your seed corn, the choices become rather more limited. This is something they apparently don’t bother to teach at the Ivy League schools.

    Everyone wants to “recapitalize” the financial system. Unfortunately, there are some inherent difficulties in doing that at the moment. I won’t belabor that point.

    On a side note, I hope that Shiela Bair’s associates are keeping up with this blog, in order that they might discover that the gravest current threat to banks at the moment is not bloggers, but rather the waiving of Section 23(a) by her obviously ill-advised colleagues at the Fed and Treasury.

    I’m sure that once this is brought to Ms. Bair’s attention she will mount a visible, vocal and very public protest … and issue a prompt and sincere apology to the bloggers who cleared things up for her.

    And hey, what about that WaMu? What a great bank! Solid as the day is long.

  6. fresno Dan

    I am a bureaucrat, (I do it because they pay me) and this is why people are wrong when they say it was a lack of regulation that caused this mess…NO! NO! NO! It was a lack of courage.
    When was the last time you heard a sustained arguement for higher interest rates? Low interest rates in booms, low interest rates after booms. And negative interest rates after crashes

  7. Anonymous

    The writer's reference to the S&L crisis is highly appropriate. As the S&Ls did back then, the FIRE sector is now doubling down its bets in a "hail Mary" play.

    If the bet pays off, then the added leverage will bring the wounded behemoths roaring back to life in a hurry, with many competitors vanquished.

    And if it don't … well, then they've just tossed a hand grenade into the financial munition dump, and we're about to see a once-in-a-lifetime fireworks display.

    Even as we speak, the "regulators" are ordering in more cases of champagne and sacks of crack. Party on, dudes!

  8. böcek ilaçlama

    In other words this “emergency measure” may potentially allow the transfer of funds from the FDIC towards the funding of BoA’s purchase of Merrill Lynch? A rathre stealthy government bailout.

  9. Danny

    Not only were regulators not enforcing the laws on the books, they were also actively manipulating markets that were fully capable of regulating themselves. The credit default swaps market has been on the edge of failure multiple times. Instead of allowing it to fail early on in its development, and teaching market players the discipline of counterparty risk, regulators intervened, and caused false signals to be sent that the CDS market was indeed safe. So in an odd twist of fate, regulators have actually increased systemic risk.

    Now we expect these very same people who oversaw these developments, who even encouraged them, to fix the problem?

  10. Richard Kline

    So Danny, no, I don’t expect those faux regulators to fix the problem: I expect them to ‘fix the solution,’ as in game the problem and spin the outcome. It’s what the top level knows so it’s what they do. It will be up to their replacements, and the successors to the present feckless Congress to fix the problem. By which time Wall Street may look like Central Italy, November, 1945, but there it is.

  11. dd

    Depends on the regulators. The Fed in the last 30 years pretty much rode rough shod over investor protection agencies and when things didn’t turn out the participants were bailed out under the banner of systemic risk. Innovation trumped regulation and you can thank Greenspan. His self-congratulatory speeches are readily available but here’s a start:
    Financial derivatives
    The mortgage market and consumer debt
    Risk Transfer and Financial Stability

    When you’re done with that go read his testimony supporting Gramm Leach and the Commodity Futures Modernization Act.

  12. Anonymous

    It’s all a shell game. Keep moving those lousy assets around as fast as possible and keep hoping and praying that somehow, someway things can get back to the heady days of financial innovation.

    It won’t work.

    But the shell games continue. And, Bernanke, Paulson et al are not the only ones moving the shells. Read the established, high end business press today and you’ll find out that Bush/Paulson drew a line in the sand and did nothing to come to the aid of LEH or Merrill.

    But, in putting deposits in play, these masterminds of the apocalypse have most certainly continued the policy of socializing losses after a Robber Baron age of privatizing gains.

  13. Anonymous

    At some level, we need to have investment banks that are more lightly regulated than commercial and consumer banks. If the government becomes the sole arbriter of what investments are “sound” and therefore worthwhile, then innovation will be choked off and the Xerox’s and Microsoft’s of the future will not succeed. But freedom to succeed equals freedom to fail. And we do NOT want failure of risky investments to imperil the funds of depositors. This is WHY we created the walls between the two in the first place. Retail banks = Safe, insured by the FDIC and heavily regulated. Investment Banks = no FDIC insurance, less governmetn regulation, the possibility of greater returns.

    There has been a slow erosion of the walls between investments, insurance and retail banking for the past few decades in the name of innovation. But you can’t build levees when the hurricaine is hours away. This has been a long time comming, and we’ve greatly increased the connections between retail banks, investment banks, the insurance business etc. The levels of debt that we have in this country are great, and for many, exceed any reasonable expectation of payment. But everything has become so linked together that we have no idea what the ultimate consequences of all the upcomming defaults will have.
    –Jim A.

  14. briareus

    Regarding the 23a rule suspension, I have an important question: Who has the authority to grant such a suspension anyway?

    I’m looking for it but so far I haven’t found who is enabled to grant such a suspension in the first place. To me it looks like the 23a and 23b of the Federal Reserve Act that dh discusses are not optional.

    Please someone enlighten or correct me.

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