Bankruptcy

Are Bank Regulators Creating More Systemic Risk?

By Adam Levitin

Systemic risk seems to be the byword for financial institutions regulators now, but a trio of developments indicates that it is only deepening:

1. Professor Anna Gelpern at Rutgers-Newark notes a scary change in Federal Reserve policy: the Fed just adopted an interim final rule (was there a notice and comment period?) that allows "all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market."

To put it in less abstruse language, the Fed is allowing insured banks to take equities (supposedly investment grade, as if that had meaning now) as collateral. So insured banks now take on their affiliates junk equity holdings as collateral and if things go badly...the FDIC insurance fund (and ultimately the taxpayers) are on the hook. I'm guessing that this means all of the bum MBS floating around insured banks' affiliates are going to go into the collateral pile. Not every bailout has to make the front page of the Times, but that's what this temporary Fed rule is...a contingent bailout.

2. As Professor Patricia McCoy of University of Connecticut School of Law observes that BoA is asking for its capital requirements to be temporarily lowered. In other words, BoA wants to become even more leveraged. This, at a time when banks are scrambling to delever.

3. Professor McCoy also notes that BoA is aksing to be and to be excused from the Riegle-Neal 10% concentration limit, which prohibits banks from obtaining more than 10% of all insured deposits via merger. BoA is already right around 10%, so to the extent it picks up anything from Merrill or a Merrill subsidiary (or any other bank), it might have problems (not that the 10% cap deterred BoA when acquiring Fleet a few years ago).

Whether the OCC and Fed will acquiese to BoA's requests remains to be seen. But these two developments put together indicate that the lessons of Fannie and Freddie have not been internalized: (1) larger institutions generate more systemic risk, especially when they are (2) highly leveraged and (3) holding junk collateral. Let's hope that in the scramble to stave off one crisis we aren't setting the stage for another much worse one.

Full post as published by Credit Slips on September 14, 2008 (boomark / email).