(Updates with description of Potomac Group in third paragraph and markets in eighth.)
Nov. 22 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and fellow U.S. policy makers may find themselves hampered in restoring financial stability should the European debt crisis spread to America.
The Dodd-Frank legislation passed last year prohibits the Fed from engaging in rescues of individual financial firms, such as it did with Bear Stearns Cos. and American International Group Inc. during the 2008 financial crisis. Lawmakers also banned the Treasury Department from again using an emergency reserve program to backstop money market funds. And the Federal Deposit Insurance Corp. now has to get Congressional approval before it can guarantee senior debt issued by banks.
Investors “don’t realize the extent to which Congress has tied people’s hands,” said Donald Kohn, who served as vice chairman of the Fed from 2006 to 2010 and is now senior economic strategist for Potomac Research Group in Washington, an independent research firm. “There is less room to maneuver for the authorities.”
In passing Dodd-Frank, lawmakers sought to end government bailouts of financial institutions deemed to be too big to fail. They beefed up regulation of the industry, required banks to hold more capital and sought to discourage excessive risk-taking by curbing the ability of the federal government to rescue them from their mistakes.
The danger is that the legislation may have gone too far in limiting the leeway of the central bank and other policy makers to act in a financial meltdown, Kohn said. The result: While crises may be less frequent than before, they may be harder to contain once they occur.
‘Play in the Joints’
“If you have a number of contagion problems all at once and are having liquidity problems, I worry that there isn’t enough play in the joints” to handle that, said John Dugan, a former Comptroller of the Currency who is now a partner with Covington & Burling LLP in Washington.
The biggest risk for now is that Europe’s sovereign debt troubles undermine the U.S. banking and financial system. The U.S. would not be able to “escape the consequences of a blowup in Europe,” Bernanke said on Nov. 10. “The world’s financial markets are highly interconnected.”
U.S. stock prices have dropped this month, largely driven by concerns about the turmoil in Europe. The Standard & Poor’s 500 Index fell to 1185.81 at 11 a.m. in New York today, down 5.4 percent for the month. Bank of America Corp. ended yesterday at $5.49, the lowest since March 2009 and was trading at $5.45 at 11 a.m. in New York today.
U.S. banks have some 125.6 billion euros ($169.4 billion) in loans to Greece, Ireland, Portugal, Spain and Italy, equivalent to about 12.5 percent of their capital, according to calculations on Oct. 25 by David Hensley, director of global economics for JPMorgan Chase & Co. in New York.
“If this is just a 50 percent default by Greece, I don’t worry about the American banking system,” said Alan Blinder, a former vice chairman at the central bank who is now a professor of economics at Princeton University in New Jersey. “If this is a 50 percent default by Italy, Spain, and, and, and, I worry about the whole world’s banking system.”
An economic calamity in Europe “is not something that we would be insulated from, although the Fed would obviously do all we could to maintain stability and to keep monetary policy easy and do whatever is necessary to try to minimize the damage,” Bernanke said at a town-hall event in El Paso, Texas.
The central bank’s ability to provide liquidity to the financial system though will be limited by the Dodd-Frank act, according to John Williams, president of the Federal Reserve Bank of San Francisco.
Tools Not Available
“Some of the tools that were deployed in 2008 and 2009 to stem a full-blown meltdown of the financial system may not be available in future crises,” he said in a speech on Nov. 11 in Washington.
The Fed can still lend money to banks via its discount window. And it can inject liquidity into the money market by buying U.S. Treasury and federal agency securities from primary dealers. What was circumscribed by Congress was the Fed’s emergency lending authority under section 13(3) of the Federal Reserve Act.
While the Fed is prohibited from bailing out individual firms under Dodd-Frank, it can use its 13(3) powers to provide “broad-based” liquidity to the financial system, as long as it gets the approval of the Treasury Secretary first, something Blinder said would not be difficult during a crisis.
“You can bail out a market like commercial paper,” he said. “You can’t bail out a bank.”
Policy makers have one big advantage they didn’t have in 2008-09, according to Blinder. They won’t have to invent a host of new emergency lending facilities. They can use some of the ones they employed just a couple of years ago.
Citing “unusual and exigent circumstances,” the Fed set up six facilities to inject liquidity into the financial system in the last crisis. They included programs to promote the purchase of commercial paper and to help finance primary dealers that the Fed uses in its operations in the money market. The facilities provided $600 billion to the financial system at their combined peak in November 2008, according to 2010 report by the Fed’s Inspector General.
One complication under the new law: the central bank has to tell selected lawmakers which financial firms are benefiting from its assistance within seven days of authorizing an emergency facility. It then has to file updates every 30 days to the House Financial Services Committee and the Senate Banking Committee.
Kohn said that may make firms wary of drawing on the Fed’s help out of fear that they will be tagged as being in trouble.
“If I were a potential borrower, I would stay away from the Fed unless I absolutely had to go,” said Kohn, who now also serves on the interim Financial Policy Committee of the Bank of England. “It might be harder for the Federal Reserve to get liquidity into the system.”
Dugan also voiced unease about the potential impact of the reporting requirement, adding that it depends on how many firms tap the facility. “If a bunch of people start using it, it becomes less of a concern,” said Dugan, who chairs his law firm’s Financial Institutions Group. “If an individual firm wants to go in on a one-off basis, it’s more of one.”
Blinder said he was not that worried and argued that investors usually know which financial firm is in trouble without having to be told that by the Fed and Congress. Besides, under the Dodd-Frank legislation -- named after former Connecticut Senator Christopher Dodd and current Massachusetts Representative Barney Frank -- the Fed can ask lawmakers to keep the identities of the recipients of its aid confidential.
Howard Gantman, spokesman for the Motion Picture Association of America, said in an e-mail that Dodd was out of the country and not available for immediate comment. Dodd is chairman of the association. Frank’s spokesman, Harry Gural, did not respond to an e-mail seeking comment.
In lieu of bailouts by the Fed, the law grants the FDIC the power to wind up bank holding companies and other systemically important institutions so they don’t have to go through bankruptcy. That’s a benefit because “the bankruptcy code tends to be both slow and rigid,” said H. Rodgin Cohen, senior chairman at law firm Sullivan & Cromwell LLP in New York.
The new format though does increase uncertainty, Kohn said. In the rescues the Fed arranged, all the creditors were made whole. That’s not likely to happen under the FDIC.
As a result, investors may be quicker to yank their money out of institutions that are in trouble, with the threat of contagion spreading to other firms, according to Kohn. “Once it gets going, they could run faster,” he said.
If that happens, the FDIC may have to go to Congress to get permission to guarantee newly issued bank debt to try to stop the panic. The trouble, said Kohn, is that legislators are unlikely to grant their approval until “things are really in pretty bad shape.”
Kohn told lawmakers in the United Kingdom in May that he “deeply regrets” the impact that the last financial crisis had on consumers. During his confirmation hearing for the Bank of England post, he said he had “placed too much confidence in private market participants to police themselves.”
Dodd-Frank gives the FDIC “what some people call draconian” powers to judge what creditors will receive when an institution is wound up, Dugan said. Holders of derivatives, including credit default swaps, can’t close out their contracts with the failed firm if the FDIC completes the resolution within 24 hours.
The problem, Dugan said, is that restriction may not apply to foreign investors because other countries have not adopted similar rules. So if a financial firm has a big derivatives operation in London or Tokyo, its counterparties there will seek immediately to close out their deals, leading to turmoil in the financial markets.
Blinder called that “a serious weakness” that would hinder the ability of the FDIC to cope with the failure of an international firm like Lehman Brothers Holdings Inc.
The San Francisco Fed’s Williams said the central bank succeeded in restoring calm to markets during the last crisis in part because it was assisted by the Treasury.
The department tapped its Exchange Stabilization Fund, which it normally uses to act in the currency markets, to finance a $50 billion guarantee program for money-market funds in September 2008. Such action has now been banned by Congress.
The Treasury also used the $700 billion Troubled Asset Relief Program that Congress passed in October 2008 to combat financial turmoil and provide capital to banks. The department’s authority to make new commitments under TARP expired last year.
Williams said it “may take considerable time” to win Congressional backing for such proposals in the future.
As a result, “the risk of runs in financial markets remains a very real concern for financial and macroeconomic stability,” he said.
--Editors: Gail DeGeorge, Christopher Wellisz
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