Call for alteration to investment bank rules

by Dave Nixon

Story link: Call for alteration to investment bank rules

Regulators should in future compel investment banks to finance themselves with longer-term debt, a requirement that would direct them to decrease their overall leverage, Don Kohn, Federal Reserve vice-chairman, said on Thursday.

The number two official at the US central bank said this would be expensive for shareholders but would make the financial system more secure and reduce the danger it posed to the wider economy.

Hank Paulson, US Treasury secretary and former chairman of Goldman Sachs, has argued for less fundamental changes. With elections threatening, the final decisions on these matters will be made by the next administration, which might not be as gracious to Wall Street.

Mr Kohn said the credit crisis had exposed that the banking system and securities market were so interwoven there was fundamentally only one credit market.

This raised a huge set of new risks for commercial banks, which have constantly been regulated because of their complete financial importance. But it also meant that policymakers could no longer overlook the systemic risks posed by investment banks.

Bear Stearns had a debt to equity ratio of about 30 times. A considerable proportion of which was in the form of overnight secured loans.

Many experts dispute that investment banks should be subject to the same capital requirements as commercial banks – requirements that effectively limit their influence. However, Mr Kohn suggested an alternative way to achieve this objective.

Supervisors should necessitate that investment banks, and commercial banks, put into practice tough liquidity risk management policies. Implementing these plans would probably require replacing overnight borrowings with pricier longer-term debt.

That would make such banks less vulnerable to any rapid loss of confidence in the wholesale funding markets, but also make them less profitable in normal times and reduce the inducement to gear up with debt.

Mr Kohn also said that the large commercial banks would have to renovate their management of risks relating to their exposure to securities markets and regulators should apply higher capital charges to activities such as the operation of off-balance sheet investment vehicles.

He warned that securitisation of mortgages and consumer loans had also had the perverse effect of increasing the concentration risk faced by small banks, left holding the loans that could not be efficiently securitised by the big banks.

Regulators fear a number of small banks could fail if the US economic downturn leads to rising default on commercial property loans, which now account for close to 50 per cent of banks’ loan portfolios.