Bair Urges More Investment Bank Oversight in Return for Fed Aid

Federal Deposit Insurance Corp. Chairman Sheila Bair called for greater oversight of investment banks, including a formula for closing them in case of insolvency, in return for access to Federal Reserve loans.

``Congress should consider whether they need to set up a system whereby there is an orderly process to close a systemically significant investment bank,'' Bair said in an interview yesterday in Washington.

Her remarks are the most explicit recommendation by a U.S. regulator on how to limit the potential cost to the taxpayer of the Fed's backstop to securities firms. While central bank loans helped stabilize the financial system after the near-bankruptcy of Bear Stearns Cos., the Fed hasn't said how it will wind them down or what rules would be required to continue the lending.

The FDIC's authority to set up bridge banks to take over and sell assets of failed lenders offers a ``good model'' for what's needed for investment banks, said Bair, 54, who took office in June 2006. She stopped short of urging Congress to expand the FDIC to cover investment banks.

Bair's agency, which insures deposits at 8,534 banks and savings associations, was given power to set up bridge banks in 1987 in the midst of the savings and loan crisis, when more than 1,000 thrifts failed.

Now, regulators are turning to the supervision of investment banks after the Fed's rescue of Bear Stearns and lending to the firms spurred criticism that the aid may encourage brokerages to take on more risk.

Fed Lifeline

The Fed Board of Governors approved $30 billion of emergency financing to secure the takeover of Bear by JPMorgan Chase & Co. in March. Officials also on March 16 approved direct lending to investment banks, the first extension of credit to nonbanks since the Great Depression.

``You need a mechanism'' to discipline the investment banks, said Robert Eisenbeis, a former head of research at the Atlanta Fed and a member of the Shadow Financial Regulatory Committee in Washington, a group that advises on rules for the industry. ``There should be a quid-pro-quo that goes along with'' access to Fed loans, he said.

The advantage of the FDIC's model for lenders is it allows the regulator to ``close and re-open an institution as a bridge bank in an orderly fashion while at the same time imposing significant penalties on market players that should be at risk,'' Bair said. ``We have the legal ability to impose significant haircuts on key stakeholders to maintain market discipline.''

Managing Risk

Bair also said that if investment banks have access to the federal safety net, a regulator should also have some say over how they manage risk, leverage and capital raising. That may help reduce moral hazard, or the danger of investors taking on more risk in the expectation of a bailout should their bets go wrong.

Her remarks come as lawmakers plan to debate the role of supervisors in coming weeks and months. House Financial Services Committee Chairman Barney Frank said April 23 that he plans to consider risk-monitoring rules aimed at avoiding government- backed bailouts.

Former St. Louis Fed President William Poole called the extension of the safety net ``appalling'' in an interview earlier this year. Paul Volcker, who led the Fed from 1979 to 1987, warned this month that the Fed's use of its balance sheet to aid investment banks invited ``political battles.''

Bair, who previously held posts at the Treasury, New York Stock Exchange and Commodity Futures Trading Commission, refrained from criticizing the central bank.

``The Fed was in a very difficult situation,'' she said. ``It didn't really have a process, it kind of had to create its own.''

No Prescriptions

Fed officials haven't commented extensively on their exit strategy for their emergency loan facilities, which have proved internally controversial.

``There is no way to put the genie back in the bottle,'' said Minneapolis Fed President Gary Stern in an April 18 interview with Fox Business Network. Stern wrote a book on the hazards of bank bailouts called ``Too Big To Fail.'' ``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?''

Chairman Ben S. Bernanke has indicated he's leaning toward more regulation, without specifying the steps he favors. New York Fed President Timothy Geithner called for ``a stronger set of incentives and requirements'' for risk management at the firms able to borrow from the Fed, in April 3 testimony at Congress.

``The problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis,'' Bernanke said in a May 13 speech.

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Bair Urges More Investment Bank Oversight in Return for Fed Aid