March 26, 2008
Paulson: Now We Regulate the I-Banks
Posted by David Zaring

The regulatory fallout of the Bear Stearns bailout just took another interesting twist.  Today former investment banker and current Secretary of the Treasury Henry Paulson called for regulation via disclosure for investment banks that want to take advantage of Fed bailouts.   

1. I know you know this, but first, Paulson explains that there's a difference between I-banks and commercial banks:

one distinction between banks and investment banks remains particularly important - banks have the advantage that they issue deposits that are insured by the Federal government. A properly designed program of deposit insurance greatly reduces the likelihood of liquidity pressures on depository institutions and as a corollary, makes the funding base of these institutions more stable. The trade-off for this subsidized funding is regulation tailored to protect the taxpayers from moral hazard this insurance creates.

2. Paulson then calls for two disclosure oriented measures, one from the government - a clear "bailout procedure" identified by the Fed - and one by industry, involving information from investment banks, done with SEC and CFTC assistance:

First, the process for obtaining funds by non-banks must continue to be as transparent as possible. The Fed should describe eligible institutions, articulate the situations in which funds will be made available, and the magnitude and pricing structure for the funds....

Second, and perhaps most importantly, the Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions...[T]he Federal Reserve, the SEC, and the CFTC ... should consider whether a more formalized working agreement should be entered into to reflect these events.....The Federal Reserve's participation could [] allow for broader consideration of market stability issues by the SEC and the CFTC. This collaborative process will necessarily have a strong focus on liquidity and funding issues.

3.  My quick take: this is a strange combination of the reasonable and the novel.  On the one hand, would you make a loan to someone if you didn't know their assets and liabilities?  If Paulson thinks that the Fed shouldn't have to make loans to investment banks without access to the balance sheets, then he's not the only one.  On the other hand, there's plenty of reasons to speculate wildly about this sort of thing, ranging from theories about turf protection by Treasury banking regulators annoyed that the Fed gets to do everything to raised eyebrows about who would be bringing investment banking within the comfortable ambit of regulated industry.

But in my view, Paulson may just be saying that he supports an effort by other agencies that he doesn't oversee to formalize and coordinate investment bank liquidity disclosure requirements.  In time honored regulatory fashion, he may be thinking that the current crisis is the best time to push for the new program.  Moreover, the agencies probably need his support to get something new like this done. 

The SEC allegedly keeps track of the liquidity of investment banks, by the way (that agency concluded that Bear Stearns had plenty of liquidity when it was collapsing). But Paulson is pretty cagey about when and how often this information would be provided to the Fed.  All the time?  With supervisors looking over the shoulders of the accountants?  Or only when a bailout might be necessary?  There's nothing about this in the speech, and really, everything turns on it.

We will have to see what the Fed, SEC, and CFTC come up with.  But for now, it shows that the one industry that is growing apace during this crisis is government.

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