A Window to a New World

The price of the Fed’s lifeline is yet to be determined.
Economist StaffJuly 7, 2008

For an industry that has seen many a defenestration over the past year, you might expect America’s investment banks to be wary of open windows. But the move in March to allow primary dealers as well as commercial banks to borrow overnight from the Federal Reserve’s discount window has calmed fears of further Bear Stearns-like death spirals. Lehman Brothers, the weakest of the remaining big investment banks, may have seen its share price pummelled as questions swirl over its business model. But no one thinks it is about to run out of cash.

What will this lifeline cost in terms of regulation? That may be clearer after Congress holds hearings on the issue, scheduled to begin on July 10th. Wall Street executives are not optimistic. “The favorite game on Capitol Hill these days is Hunt the Investment Banker,” sighs one.

Initially opened for six months, the window will almost certainly be kept ajar when that period ends in mid-September, given the continued market instability. Lehman is not alone in being glad of the protection. Merrill Lynch faces further write-downs and may report another quarterly loss in mid-July. Even Goldman Sachs, Wall Street’s sole surviving muscleman, sees the loan facility as systemically crucial. Though the amount borrowed has fallen to a daily average of $6 billion, closing it would cause “mayhem” by inviting speculative attacks, particularly against Lehman, reckons another banker.

The first piece of the quid pro quo is already in place. By sending teams of officials into the investment banks, the Fed has in effect usurped the Securities and Exchange Commission (SEC) as their main regulator. The two are working on a formal agreement that will clarify how they share information, and give the Fed greater access to the banks’ trading positions. The future division of responsibility remains unclear, however. The likeliest outcome is a double-headed regime, with the Fed as a stability regulator for large financial institutions of all types, and the SEC policing investor protection. But Christopher Cox, the SEC’s chairman, is under pressure—both internally and from several predecessors—not to cede ground.

This looks like just the beginning of the shake-up. “We lack appropriate constraints on risk-taking at investment banks,” says Barney Frank, the head of the House financial-services committee. Mr Frank wants Wall Street to be subjected to capital requirements similar to those for stodgier commercial banks (which are lobbying vociferously for the gap to be closed). But investment bankers argue that this would put them at an unfair disadvantage, since they have to mark their assets to market, whereas commercial banks can hold large chunks at historic cost.

As well as being coaxed into reducing leverage, the banks may face pressure to ditch some of their illiquid assets, such as mortgage-linked securities and private-equity stakes. Regulators are said to be mulling an “aged inventory capital charge”, which would penalise banks that held paper for longer than, say, one month. Another proposal is to limit their venture-capital and hedge-fund holdings. Yet another would raise the capital charge on loan commitments.

Funding is under the spotlight, too. Investment banks have already rushed to reduce their reliance on overnight funding in repo markets, after lenders lost faith in the securities used as collateral. Regulators want to encourage more long-term funding and deposit-taking. Though stable, however, deposits are a more expensive form of finance than repo markets for banks that lack branch networks.

The banks’ balance-sheets are not the only cause for concern. There is also no clear mechanism for winding down a failing investment bank. Sheila Bair, head of the Federal Deposit Insurance Corporation, has suggested extending the “bridge bank” model already in place for commercial lenders—which maintains key businesses while selling off assets. In a speech this week, Hank Paulson, America’s treasury secretary, placed this issue at the top of his agenda.

None of this will be good for Wall Street’s profitability. Analysts expect the industry’s return on equity to fall by a third or more over the cycle. Bob Gach, head of the capital-markets practice at Accenture, a management-consulting firm, thinks the new shackles will hasten the demise of the stand-alone investment bank—though Goldman and, to a lesser extent, Morgan Stanley may remain as exceptions. In a recent op-ed article, Mr Cox looked forward to a “brave new world” of financial regulation. For Wall Street’s erstwhile high-fliers, it will be an unsettling one.