Federal Deposit Insurance Corporation Chairwoman Sheila Bair said today she worries that Senate Banking Committee Chairman Christopher Dodd's new financial reform bill (.pdf) could provide backdoor bailouts. She made the comments during a speech at the annual convention of Independent Community Bankers of America. In particular, she worries that Dodd's bill gives the Fed the ability to continue bailing out out systemically relevant firms. I found this puzzling. I spent an enormous amount of time digging through the bill and didn't remember seeing that. So I checked again, and I still think Dodd's bill doesn't do with Bair thinks.

In talking about ending too big to fail, here's what Bair said:

However, we do have serious concerns about other sections of the Senate draft which seem to allow the potential for backdoor bailouts through the Federal Reserve Board's 13(3) authority. We will work closely with the Senate to make sure there are no loopholes around the carefully crafted resolution procedures. If the Congress accomplishes anything this year, it should be to clearly and completely end too big to fail.

Here's the excerpt from the Senate bill that I'm pretty sure she's referring to (sec. 1151, pgs.1302-1303):

The third undesignated paragraph of section 13 of the Federal Reserve Act (12 U.S.C. 343) (relating to emergency lending authority) is amended--
     (1) by inserting ''(3)(A)'' before ''In unusual'';
     (2) by striking ''individual, partnership, or corporation'' the first place that term appears and inserting the following: ''financial market utility that the Financial Stability Oversight Council determines is, or is likely to become, systemically important, or any program or facility with broad-based eligibility'';

So the Fed does still have power to provide emergency lending authority, but instead of to an "individual, partnership, or corporation," Dodd would change that to a "financial market utility." So the question, then, is what's a financial market utility? The bill defines that as (sec. 803 pg. 723):

The term ''financial market utility'' means any person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.

The way I read that, Dodd means a financial market utility to be something like a clearing house or payment system. For example, if DTC or CLS Bank somehow needed a bailout, then the Fed would step in and make sure business could continue. I don't know about you, but I'd be very scared of a world where a major financial market utility, as defined above, failed. Chaos would ensue; financial markets would grind to a messy halt.

There's no way to resolve a financial market utility as defined above without causing a major economic disturbance. No resolution authority could accomplish the task. That's why Dodd wants these institutions regulated as utilities.

But I don't think that provides a bailout to any big bank like Goldman Sachs or Citigroup. These banks don't run clearing houses -- and if they do, they shouldn't. The Fed should be able to take over financial market utilities without saving any big banks in the process -- just those who only serve a clearing house or payment settlement function. The purpose here would merely be to make sure that transactions could continue to be processed. That's absolutely essential for financial stability.

Now, if I do not correctly understand the definition of a financial market utility above, and Dodd does mean for big banks to be shielded from failure, then I agree completely with Bair. But I don't think that's what's going on in the bill. Indeed, why would Dodd have bothered striking "individual, partnership or corporation" if he meant for systemically relevant firms to receive emergency rescues from the Fed?

Update: I just spoke with Senate Banking Committee spokesperson Kristin Brost. She tells me that references to "financial market utility" from the Fed's section have been removed from Dodd's proposal -- and Bair's office was notified of this last night.

I'm going to have to wait to see the revised version after mark-up to see where this leaves us. I thought it made sense to keep such financial market utilities going. But maybe it was just the terminology that the FDIC worried about. Presumably, neither Dodd nor Bair wants the Fed to bail out individual institutions. I don't either. I just hope this change allows the Fed to keep clearing houses, payment settlement systems, etc. going. That's pretty important for financial stability. And such institutions should be regulated as utilities.

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