NY Fed chief contemplates pre-emptive bailouts

Fed Could Offer 'Liquidity Backstop' to Some Firms, Dudley Says

By Vivien Lou Chen and Sandrine Rastello
Bloomberg News
Saturday, November 14, 2009

http://www.bloomberg.com/apps/news?pid=20601087&sid=aA4Gukum9lY8&pos=6

Federal Reserve Bank of New York President William Dudley said the central bank could curtail the risk of future liquidity crises by providing a "backstop" to solvent firms with sufficient collateral.

"The central bank could commit to being the lender of last resort" to such firms, Dudley said in a speech yesterday in Princeton, New Jersey. This would reduce "the risk of panics sparked by uncertainty among lenders about what other creditors think."

Dudley said he's confident regulators can create policies to reduce the risk of future liquidity runs like the ones that struck Bear Stearns Cos., Lehman Brothers Holdings Inc., and American International Group Inc. The international Basel Committee on Banking Supervision is reviewing ways to require banks to hold more and higher-quality capital, he said.

The New York Fed chief's comments coincide with consideration by Fed officials of ways to withdraw a record $1 trillion of liquidity channeled into the financial system to avert a depression. The New York Fed said last month it's working with market participants on using reverse repurchase agreements to drain cash from the banking system.

"Liquidity risk will never be eliminated, nor should it," the bank president said. "However, we can do better to make our system less prone to the types of liquidity runs that we have experienced."

"If we remain committed to implementing the reforms that are already under way, I am confident that we can dramatically reduce the risks of the type of liquidity crises that we experienced all too recently," the New York Fed chief said at a Center for Economic Policy Studies symposium.

Dudley, 56, serves as vice chairman of the rate-setting Federal Open Market Committee. He did not comment on the outlook for the economy or policy in his speech.

The Fed is facing the biggest threat to its independence in five decades under legislation proposed by Sen. Christopher Dodd, a Connecticut Democrat. He released draft legislation this week that would create a single regulator for banks, leaving the Fed to focus on monetary policy. By contrast, the Obama administration plans to expand the Fed's authority to oversee the biggest financial companies.

U.S. lawmakers are drafting the most sweeping overhaul of financial regulation since the Great Depression after a collapse of the subprime-lending market triggered $1.67 trillion in credit losses and writedowns at banks and other financial institutions.

"The central bank could provide a liquidity backstop to solvent firms," Dudley said. "If the central bank is willing to provide backstop liquidity, then a lender that judges the financial firm to be solvent should be willing to lend."

In response to audience questions, Dudley said he expects problems in the commercial real-estate market to persist "for quite a period of time."

"It's quite significant for the health of the commercial banking system," he said. "It's going to retard the rate and speed at which the U.S. commercial banking system returns to health."

At the same time, weakness in commercial real estate doesn't pose a systemic risk and will probably trouble regional banks more than large ones, he said.

"The orthodoxy of the Fed" on how it should respond to asset-price bubbles "is shifting a little bit," he said. Dudley said it's possible to identify asset bubbles or at least the risk of asset bubbles "to some degree."

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