Wednesday, June 18, 2008

Bair wants FDIC prepared for IB failure

FDIC Chairman Sheila Bair in a speech argues for the implementation of a playbook to deal with a potential failure of a large investment bank. This could be seen similar to what is already a standard protocol for commercial banks. Though Bair insists that the failure of a large bank remains highly unlikely ("I am certainly not predicting one") it is no longer unthinkable.

Should we view the extension as a one-time event or as permanent? In my view, it is almost impossible to go back. As Gary Stern has said, "There is no way to put the genie back in the bottle. Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done?"

If this is the case, it makes sense to extend some form of greater prudential regulation to investment banks as well as a process or protocol for dealing with a systemically significant investment bank approaching failure. The government cannot be put in the position of having to simply write a blank check when these institutions get into trouble.

At a minimum, there should be greater parity between commercial banks and investment banks over how they manage risk, liquidity and capital. There should be a Prompt Corrective Action-like mechanism with mandatory triggers for supervisory intervention and, if necessary, closure if capital is not restored. While many cite Bear Stearns and Northern Rock as liquidity failures, they were both over-leveraged. Greater capital improves access to liquidity.

However, this is not meant as criticism of the Fed. There is a playbook for the failure of a commercial bank, even a systemically important one, but there isn't any for the failure of an investment bank. The Fed had to invent one on the fly. The Fed was in essentially the same boat as the FSA, which had no ready mechanism for handling the failure of Northern Rock. Lack of a playbook was part of the reason the UK had to protect all depositors and nationalize the bank.

source: Remarks by FDIC Chairman Sheila Bair to the Exchequer Club of Washington D.C.
June 18, 2008

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