WASHINGTON — The government's crisis management efforts this weekend stuck a few more fingers in the dike to prevent a meltdown in the financial sector, but observers are questioning whether two moves in particular ratcheted up the risks facing the Federal Deposit Insurance Corp.
Bank of America Corp., the FDIC's biggest customer, with 10% of the nation's deposits, made another enormous deal, this time for Merrill Lynch & Co. Inc., and it is unclear how much the acquisition would increase B of A's risk profile. (See related story.)
Also, the Federal Reserve Board waived long-standing limits designed to prevent commercial banks from bailing out affiliates, including their investment banking units. The waiver, which will last through January, was seen helping B of A make the Merrill deal.
"That's specifically so that no one will question Bank of America's ability to capitalize Merrill Lynch because it allows Bank of America to use its deposit base, which is enormous, to capitalize the broker dealer," said Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial Capital Markets. "It gives them time to start accumulating other types of cap to back up Merrill."
These issues are expected to come up Thursday, when regulators are scheduled to testify before the Senate Banking Committee. Lawmakers are increasingly worried about the FDIC's ability to pay for a growing number of bank failures, and relaxing the barriers between banks and riskier affiliates is likely to raise some concerns.
"Those regulations are in place for really important reasons — to keep investment banks out of the Deposit Insurance Fund," said Joseph Mason, a professor at Louisiana State University. "Commercial banks are functionally regulated, and because of that, we give them this safety net. Investment banks are at the other end of the spectrum."
The easing is a part of a larger response in Washington to dramatic convulsions on Wall Street. To help banks with exposures to the now-bankrupt Lehman, the Fed said it would accept a broader range of collateral at the discount window, most notably equities. The central bank is boosting the amount of Treasury securities it will offer through weekly auctions by $25 billion, to $200 billion.
A group of 11 banking companies, including B of A, Citigroup Inc., and JPMorgan Chase & Co., established a $77 billion fund as an alternative of sorts to the discount window. (Each company is putting up $7 billion.)
Mr. Low said the fund may be a first step toward moving the industry away from its reliance on the government.
"The Fed would love to see the banks weaned off of Fed lending," he said. "The original plan earlier this year was the Fed lending facilities would start to close down, and that's not going to happen now, but at some point we need to get the private sector financing itself. This is a good first step."
Investment banks have not borrowed from the window in nearly three months, but commercial bank borrowing surged 23.4% last week.
Mr. Low argued that the new rules on affiliate transactions would encourage banks to take on riskier deposits to increase liquidity that could then be directed to struggling investment bank units.
"The initial worry for the FDIC is that deposits will be used to backstop investment banking operations, which in and of itself is risky," he said. "The second problem is other deposit-taking institutions may be forced to pursue riskier ventures to cover the cost of borrowing."
The Fed did not consult the deposit insurer before deciding to waive Rule 23A.
Recent events have demonstrated that the Deposit Insurance Fund's reserves can drop rapidly. Last quarter the FDIC set aside more than $10 billion of loss reserves, largely because of the IndyMac Bancorp failure in July. That provision pulled reserves down 14%, to $45 billion, or just 1.01% of insured deposits. (Since IndyMac, seven institutions have failed). The ratio is 14 basis points below the minimum level at which the agency is required to restore its reserves, most likely with higher assessments on the industry.
The FDIC has assured the public that its premium-setting ability will likely stave off any need to go to the Treasury for insurance reserves, though the ability to borrow from the Treasury is another line of defense for borrowers.
FDIC Chairman Sheila Bair said Monday that her agency is "monitoring the situation" posed by risks in the investment bank sector. The FDIC has "taken steps to mitigate any impact on insured institutions that may be directly affected by Lehman Brothers bankruptcy filing."
Under the Fed's Rule 23A changes, banks may finance only the type of assets they would have used in the tri-party repurchase market, and transactions must be marked to market daily. The rule also limits institutions' aggregate risk profile to Friday's level of tri-party purchase agreements and requires the holding company to guarantee the obligations.
The Fed also reserved the right to withdraw the exemption on a case-by-case basis. Most observers admitted the waiver on affiliate transactions is problematic, but few said the Fed had better options.
"There are no good choices here," said Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc. "None of this is anything people wanted to do."
Borrowing from the new industry fund will be limited to its 11 members, and details such as terms, acceptable collateral, and rates were not disclosed Monday.
"You can think of the $77 billion as a self-insurance mechanism. The bulge-bracket banks each put up money to backstop their industry against further turmoil. It is a gesture to instill confidence, and it is also a real alternative to tapping the Fed," said Eugene A. Ludwig, the chief executive of Promontory Financial Group. "It's a bit of a belt-and-suspenders approach, but in this market there is no such thing as too much liquidity."
The group said membership in the fund could increase as other institutions join, though the process of becoming a member is unclear. Royal Bank of Scotland Group PLC joined the group Monday.
No one bank will be able to borrow more than a third of the total funds at one time, but spokesperson at a firm coordinating its development said "there's a good chance" the fund "will never be accessed especially since the Fed has expanded its access to its window."
This source said the firms acted entirely on their own. "It was the industry's idea. The industry wanted to show they had confidence in the system and so they formed this facility."
The response to the fund was generally supportive, but many questioned whether the Fed may be overwhelmed. Its lending facilities have absorbed nearly half its $924 billion balance sheet.
"There's not a lot of room to go," Mr. Mason said. "They've used the balance sheet too freely, in my opinion, trying to put out fires."
Of course, the Fed can expand its balance sheet as it sees fit.
"It's not that the Fed has a limited supply of funds, because they can create all they want," said Gil Schwartz, a former Fed lawyer who now works in private practice. "This is all political and not economic."