Monday, March 24, 2008

Wall Street, meet Fed

Are the Federal Reserve's recent efforts to stop investment bank failures, while providing credit to non-commercial banks, a sign of its future involvement on Wall Street?

Writers at the Financial Times and Barron's believe it is.

While doing a bit of weekend reading, I came across the following article in the weekend edition (March 22/March 23 2008) of the Financial Times.

Entitled, "Wall St detects shift in regulatory power", the piece outlined the possibility of a new "unified regulatory regime" that would involve closer Fed supervision over Wall Street investment banks:

"With the credit crunch worsening and public money at stake, the Fed and the Treasury are taking a hands-on approach to the oversight of Wall Street banks, whose primary regulator for the past 70 years has been the Securities and Exchange Commission.

Senior bankers say that officials from the Treasury and the Fed are in constant contact with Wall Street firms, checking on their liquidity and capital position, in an effort to avoid a repeat of the Bear disaster.

"There is a real sense that this group is now in charge," said a Wall Street banker. "They are committed to doing whatever it takes to sort this mess out, and feel they have real responsibility for dealing with global financial stability."

Fed policymakers acknowledge it is not ideal for them to lend funds to institutions they do not formally oversee and which are more lightly regulated than commercial banks.

And Wall Street observers note that the SEC is not equipped to deal with crises of this magnitude because its main role is to police trading and markets, not to supply liquidity to credit-starved investment banks.

The question is whether the increased involvement of the Fed in Wall Street's daily activities will raise the pressure for wholesale change in a US regulatory regime that dates back to the 1930s."

Barron's columnist Randall Forsyth was also on the trail of this new development, drawing parallels to the 1907 panic and the aftershocks which led to the creation of the Federal Reserve.

Here's an excerpt from his article, "Should the Fed regulate Wall Street?":

"JUST OVER A CENTURY AGO, THE PANIC OF 1907 LED TO the creation of the Federal Reserve, and with it, increased support and regulation of the U.S. banking system.

The Panic of 2008 has spurred a vast expansion of the Fed's powers and responsibilities, from traditional commercial banking to the entire financial markets. Already the calls are being heard for comparable regulation of institutions that now, effectively, have become the central bank's charges."

Meanwhile, today's FT Lex column wonders about the regulatory backlash that could come about if "private losses socialized by the public sector do become drastic".

"The severity of the fallout from today’s crisis partly depends on the scale of loss borne by the public sector. So far central banks can, just about, present their activity as that of lenders of the last resort: lending to banks (and now dealers) in return for good collateral. Even the UK Treasury says nationalised Northern Rock’s assets exceed its liabilities.

But it is easy to imagine scenarios in which the public sector bears large and explicit costs. The collateral’s value could fall; central banks might feel obliged directly to prop up the prices of risky assets; bailouts of clearly insolvent banks might occur. High inflation might conceivably be tolerated to cut the real value of private debt – as Professor Niall Ferguson puts it, a re-creation of the 1970s to avoid the 1930s."

Hmm. I thought this (central banks propping up risky assets, high inflation) was already happening.

Well, at least things are working out for JPMorgan. Despite having to raise their purchase price for Bear Stearns, they still have a little help from the Fed (and the taxpayers) in closing this deal.

It's no wonder that some at the investment banks are "relaxed" at the prospect of further Fed involvement on Wall Street.