Fed Keeps Watch on Wall St. -- From the Inside

By Neil Irwin
Washington Post Staff Writer
Tuesday, May 27, 2008

In the two months since the government rescue of Bear Stearns, the Federal Reserve has built on the fly a new system of monitoring investment banks, radically redefining the central bank's role overseeing Wall Street.

New York Fed employees are working inside major investment banks every day, alongside the Securities and Exchange Commission staff members who are the firms' main regulators. The Fed employees are trying to gather information the central bank can use to make sure the billions of dollars it is lending the investment firms, through a special emergency loan program enacted in March, are not being put at undue risk.

This new approach, which is still at a relatively small scale, offers a window into how the nation's system of regulating financial firms might evolve as policymakers sift through the financial wreckage of the past nine months.

The Bush administration has proposed that the Fed become an all-purpose guarantor of the financial system, with the power to poke its head into any company that poses risks -- not just the large commercial banks it now supervises. Congress is likely to consider legislation overhauling financial regulation next year.

"Bear Stearns has forced an issue that we should have been thinking about anyway," said Douglas Elmendorf, a senior fellow at the Brookings Institution. "The issue isn't just that the Fed did this thing in March. It's that the Fed did what it did in March because investment banks posed risks to the overall financial system and the economy."

But it also creates risks. With the Fed having made emergency funds available to investment banks, lenders and those who work with them might become complacent about risks, expecting a government bailout if anything goes wrong. That could destabilize the financial system further.

"Once the Fed starts investigating and looking at the risks that they're taking, the market could back off and say, 'Well, the Fed's in there, so there can't be much risk,' " said Peter J. Wallison, who studies financial regulation at the American Enterprise Institute.

The Fed currently lacks the legal authority to order investment banks to strengthen risk control systems or change their accounting for exposure to complicated derivatives. The SEC has those powers, though its historical mission has been to ensure that investors are protected, not to protect the integrity of the financial system as a whole.

On March 16, the Fed backed the emergency acquisition of Bear Stearns by putting $30 billion (since changed to $29 billion) in public funds at risk and opened an emergency lending window that last week lent $14.2 billion to investment firms.

Both actions, meant to prevent panic from causing a cascade of failures that could have had a catastrophic impact on markets and the world economy, defied 90 years of precedent, insinuating the central bank into the workings of Wall Street as never before.

Fed leaders concluded that they would have to step up their involvement in Wall Street, if only to make sure that those loans were likely to be paid back. So it insisted that banks, in exchange for the new lending, open up about the details of their operations -- a deal that the investment firms readily agreed to.

They have not, however, reached any firm conclusions about what form the ultimate regulation of the financial system ought to take and are not presuming that the improvised system established in the past two months will expand and become permanent once Congress acts.

CONTINUED     1        >

© 2008 The Washington Post Company