If the Federal Reserve is waiving a fundamental
principle in banking regulation, the credit crunch must still be
sapping the strength of America's biggest banks. Fortune's Peter Eavis
documents an unusual Fed move.
By Peter Eavis, Fortune writer
NEW YORK (Fortune) — In a clear sign that the
credit crunch is still affecting the nation's largest financial
institutions, the Federal Reserve agreed this week to bend key banking
regulations to help out Citigroup and Bank of America, according to documents posted Friday on the Fed's web site.
The Aug. 20 letters from the Fed to Citigroup and
Bank of America state that the Fed, which regulates large parts of the
U.S. financial system, has agreed to exempt both banks from rules that
effectively limit the amount of lending that their federally-insured
banks can do with their brokerage
affiliates. The exemption, which is temporary,
means, for example, that Citigroup's Citibank entity can substantially
increase funding to Citigroup Global Markets, its brokerage subsidiary.
Citigroup and Bank of America requested the exemptions, according to
the letters, to provide liquidity to those holding mortgage loans,
mortgage-backed securities, and other securities.
This unusual move by the Fed shows that the largest
Wall Street firms are continuing to have problems funding operations
during the current market difficulties, according to banking industry
skeptics. The Fed's move appears to support the view that even the
biggest brokerages have been caught off guard by the credit crunch and
don't have financing to deal with the resulting dislocation in the
markets. The opposing, less negative view is that the Fed has taken
this step merely to increase the speed with which the funds recently
borrowed at the Fed's discount window can flow through to the bond
markets, where the mortgage mess has caused a drying up of liquidity.
On Wednesday, Citibank and Bank of America said that
they and two other banks accessed $500 million in 30-day financing at
the discount window. A Citigroup spokesperson declined to comment. Bank
of America dismissed the notion that Banc of America Securities is not
well positioned to fund operations without help from the federally
insured bank. “This is just a technicality to allow us to use our
regular channels of business with funds from the Fed's discount
window,” says Bob Stickler, spokesperson for Bank of America. “We have
no current plans to use the discount window beyond the $500 million
announced earlier this week.”
There is a good chance that other large banks, like
J.P. Morgan, have been granted similar
exemptions. The Federal Reserve and J.P. Morgan didn't immediately
The regulations in question effectively limit a
bank's funding exposure to an affiliate to 10% of the bank's capital.
But the Fed has allowed Citibank and Bank of America to blow through
that level. Citigroup and Bank of America are able to lend up to $25
billion apiece under this exemption, according to the Fed. If Citibank
used the full amount, “that represents about 30% of Citibank's total
regulatory capital, which is no small exemption,” says Charlie Peabody,
banks analyst at Portales Partners.
The Fed says that it made the exemption in the
public interest, because it allows Citibank to get liquidity to the
brokerage in “the most rapid and cost-effective manner possible.”
So, how serious is this rule-bending? Very. One of
the central tenets of banking regulation is that banks with federally
insured deposits should never be over-exposed to brokerage
subsidiaries; indeed, for decades financial institutions were legally
required to keep the two units completely separate. This move by the
Fed eats away at the principle.
Sure, the temporary nature of the move makes it look
slightly less serious, but the Fed didn't give a date in the letter for
when this exemption will end. In addition, the sheer size of the
potential lending capacity at Citigroup and Bank of America – $25
billion each – is a cause for unease. Indeed, this move to exempt
Citigroup casts a whole new light on the discount window borrowing that
was revealed earlier this week. At the time, the gloss put on the
discount window advances was that they were orderly and almost symbolic
in nature. But if that were the case, why the need to use these
exemptions to rush the funds to the brokerages?
Expect the discount window borrowings to become a
key part of the Fed's recovery strategy for the financial system. The
Fed's exemption will almost certainly force its regulatory arm to
sharpen its oversight of banks' balance sheets, which means banks will
almost certainly have to mark down asset values to appropriate levels a
lot faster now. That's because there is no way that the Fed is going to
allow easier funding to lead to a further propping up of asset prices.
Don't forget: The Federal Reserve is in crisis
management at the moment. However, it doesn't want to show any signs of
panic. That means no rushed cuts in interest rates. It also means that
it wants banks to quickly take the big charges that will inevitably
come from holding toxic debt securities. And it will do all it can
behind the scenes to work with the banks to help them get through this
upheaval. But waiving one of the most important banking regulations can
only add nervousness to the market. And that's what the Fed did Monday
in these disturbing letters to the nation's two largest banks.
We wonder how much assistance the Bank of England and the European Central Bank (ECB) has provided this side of the pond, and how much regulatory bodies have allowed the rules to be relaxed.