Reform Bills Would Limit Fed Largesse

In the war on the "too big to fail" doctrine, Congress is targeting a new culprit: the Federal Reserve's discount window.

The omnibus banking bills moving through the House and Senate would bar the the central bank from making secured loans to undercapitalized institutions for more than 60 days in any 120-day period, unless it meets one of two conditions.

The first involves a supervisory seal of approval. The Fed could lend longer than 60 days if the institution's primary supervisor certifies that the institutions is likely to survive.

The second exception permits the Fed to continue lending without a viability certification, but it would be at risk in the event the bank failed. The Federal Deposit Insurance Corp. could force the Fed to cover some of the losses, as though the central bank were an unsecured borrower.

Advocates of restrictions hope to force early resolutions of troubled banks by cutting off a traditional life support system. But critics warn that it is potentially destabilizing to inhibit the Fed from fulfilling its role as liquidity lender for the industry.

"No central bank in the world lends on an unsecured basis," said Sen. Phil Gramm, R-Tex. "It would discourage the Fed from serving as lender of last resort."

Until now, much of the wrath over "too big to fail" has been directed at the FDIC, which routinely protects uninsured depositors at failed banks by moving deposits to another institution.

Gonzalez Weighs In

But House Banking Committee Chairman Henry B. Gonzalez, D-Tex., brought the Fed into the fray with a recent study showing that the central bank keeps failing institutions alive for months and even years by advancing credit through the discount window.

Looking at data on all insured institutions that borrowed from the Fed between January 1985 and March 10, 1991, Mr. Gonzalez found that 90% of the banks that received extended credit ultimately failed. Moreover, he said, the Fed routinely extends credit to banks with a Camel rating of 5 - the lowest score given by regulators.

The central bank takes a realistic approach toward risk, however, according to the Gonzalez study. It not only takes the highest-quality assets from the borrowing institution as security, it demands collateral "in an amount substantially in excess of the loan amount."

Burden Is on FDIC

As a result, the Fed is shielded from the consequences of its lending decisions. If it unwisely keeps a bank open while losses build, the FDIC bears the cost, not the Fed.

Robert Litan of the Brookings Institution said the system would benefit if the Fed shared in losses from bad lending decisions.

"I want the Fed to have an incentive to beat on the primary regulator to do its job," said Mr. Litan. However, he also wants the Fed to continue to play a role in keeping large-but not small-institutions afloat.

"I'm worried about systemic risk," he said.

Other proponents of curbs believe that limits on discount window lending would help bring market discipline to the banking system. Uninsured depositors have been the beneficiaries of insurance more often than not, and the Fed's lending activities give them a bit more breathing room, critics charge.

"Ninety percent of the time, the bank fails," said Senate Banking Committee Chairman Donald W. Riegle of cases where the Fed lends money for an extended period.

"The uninusred depositor beats it out the side door and when the bank goes down, and the Fed gets paid off," the Michigan Democrat added.

Uninsured Deposits Flee

Alexandria, Va.-based analyst Bert Ely agrees. He said call report data suggest that at least $5 billion in uninsured deposits safely left Bank of New England while the Fed pumped credit into the failing bank.

Edward L. Yingling, chief lobbyist for the American Bankers Association, said the Fed should not be inhibited from meeting "appropriate short-term liquidity needs" of individual banks.

But he worries that the discount window has been a pillar supporting the too-big-to-fail doctrine. "It doesn't do much good to push too-big-to-fail out of the FDIC, but then give it to the Fed."

Still, many observers believe the Fed and its fellow regulatory agencies would find ways around the curbs proposed by the House and Senate Banking Committees.

"I'm under no illusions," said Mr. Litan of Brookings. "If they are faced with a big failure, they will find a way to protect uninsured depositors."

And Mr. Ely noted that the Senate bill, while curbing the Fed, opens up a whole new discount window by permitting the FDIC to borrow from the Federal Financing Bank "to provide liquidity to insured depository institutions."

"It's like squeezing a balloon," he said. "You push in on one spot and it bulges out in another."

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