Paulson Bair Want System for Investment Bank Closure

U.S. Treasury Secretary Henry Paulson joined Federal Deposit Insurance Corp. Chairman Sheila Bair in seeking a clear procedure for shuttering a failing investment bank in the aftermath of the Bear Stearns Cos. crisis.

The Federal Reserve and Securities and Exchange Commission are also close to an agreement on getting information about securities firms' capital and leverage in return for access to loans from the Fed. Meantime, Paulson today urged changes in the markets for derivatives and short-term funding markets so they can withstand the failure of a counterparty.

Regulators aim to limit the dangers that firms take on more risk in the confidence of a Fed rescue if their bets go wrong. Supervisors agree that stronger oversight of the industry is needed, including interim steps before Congress considers a longer-term overhaul.

``It makes me wonder if we haven't taken the Iraq strategy'' with the start of Fed lending to investment banks -- ``which is going in without an exit strategy,'' Joshua Rosner, managing director at Graham Fisher & Co, a New York research firm, said in a Bloomberg Television interview.

Paulson said it needs to be made clear what happens to financial firms that aren't part of the commercial banking system and don't have access to the same safety net. Market ``discipline'' must be strengthened, with firms not expecting that central bank aid will be ``readily available,'' he added.

Impact on System

``There still seems to be uncertainty surrounding the process by which a large complex institution is wound down and what impact it would have on the overall financial system,'' Paulson said. Regulators should determine whether to assign a specific agency to oversee resolutions, he said.

Bair, whose agency insures deposits at 8,534 commercial banks, told reporters yesterday the FDIC ``would not turn it down'' if Congress gave it the authority to shut down failing investment banks. She said last month the FDIC's authority to set up bridge banks to take over and sell assets of failed banks offered a ``good model'' for what's needed for investment banks.

Responding to questions after his speech, Paulson said Bair's idea for a resolution plan for troubled financial firms was ``dead on.''

``We must limit the perception that some institutions are either too big or too interconnected to fail,'' Paulson said at the Women in Housing and Finance annual luncheon. ``If we are to do that credibly, we must address the reality that some are.''

Cox's Goal

Securities and Exchange Commission Chairman Christopher Cox indicated his agency warrants additional authority over investment banks, in an opinion piece in the Wall Street Journal today. It's ``vital'' for Congress to give authorization for the SEC's current voluntary program of supervising securities' firms capital and leverage ratios, he wrote.

Paulson said the Fed's role should be broadened, repeating his call in a March ``blueprint'' for a regulatory overhaul.

``Our nation has come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk. But, as we noted in our Blueprint, the Fed has neither the clear statutory authority nor the mandate to anticipate and deal with risks across our entire financial system,'' Paulson said.

As an interim step, the Fed and SEC are discussing a ``memorandum of understanding'' to address what information and access the central bank needs in return for loans to investment banks.

Nearing Agreement

The two agencies are close to completing the agreement, Erik Sirri, who heads the SEC's trading and markets division, said today in testimony to a congressional hearing. He also said the SEC is urging Wall Street firms to reduce their ``dependency'' on transactions with terms as short as one day for funding.

Paulson, Cox and Fed Chairman Ben S. Bernanke and their staffs are in almost daily discussions about the future of the so-called Primary Dealer Credit Facility, according to an official who spoke on condition of anonymity.

The Treasury and SEC want the program, designed to be in place until at least September, to be temporary. The discussions with the Fed center in part on what precautions might need to be in place in case a large securities company with hundreds of trading counterparties faces failure, as was the case with Bear Stearns.

Paulson also today called for improvements in the derivatives and repurchase markets to prevent bottlenecks that could roil the financial system.

`Massive Scale'

``Given the massive scale of the over-the-counter derivatives market, we need to enhance trade processing with more automation, clear the backlog and create utilities and protocols that will make the process more efficient,'' Paulson said.

The New York Fed this month convened a group of banks to encourage them to address risks in the $62 trillion market for credit-default swaps. Seventeen banks agreed to create a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers.

Fed Vice Chairman Donald Kohn today said it's important for the clearinghouse to ``have financial resources to that it can withstand the failure even of its largest participant.''

``A central clearinghouse can reduce risk, but it concentrates risk,'' Kohn said in responding to questions at the Senate Banking subcommittee attended by Sirri. The entity must be ``very, very strong.''

Repo Market

Regulators also are monitoring repurchase agreements, also known as repos, which banks use for short-term financing.

In a common arrangement known as tri-party repo, one bank lends money to another bank, which offers securities as collateral. A third party, known as a clearing back, takes on a safeguarding role in the transaction.

``We must address risks associated with a potential counterparty failure and the risk associated with the potential disruption of a clearing bank'' in the repo market, Paulson said.

JPMorgan Chase & Co. and Bank of New York Mellon Corp. are the two clearing banks for repo transactions.

The Fed uses repos for its open-market operations, which keep the rate on overnight loans between banks close to the target set by policy makers. The head of the New York Fed's markets group said May 15 that the central bank is taking a more active role in the repo markets through a recently added emergency lending program for investment banks.

``The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort,'' New York Fed Executive Vice President William Dudley said. ``This bolsters confidence in the tri-party repo system and reduces the risk of the type of funding run that led to Bear Stearns' illiquidity crisis.''

Frank's Support

Comptroller of the Currency John Dugan also said today that investment banks need more oversight. ``We can't be handing out the government's credit without having government supervision of it to make sure its credit is protected,'' Dugan said in an interview with Bloomberg News.

House Financial Services Chairman Barney Frank, a Massachusetts Democrat, said he supported Paulson's view that the Fed needs authority to access information and act to mitigate systemic risk before crises happen.

``The secretary correctly observes that our regulatory apparatus has not kept up with the transformation of our financial markets,'' according to an e-mailed statement from Frank, who will hold hearings on regulatory changes next month.

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Paulson Bair Want System for Investment Bank Closure