The great bank bail-out – good policy

The only banks using the discount window have been four big money center banks – Bank of America, JPMorgan Chase, Citibank, and Wachovia. Each borrowed $500 mm. The additional policy twist is the fact that the Fed is willing to take ABS CP collateral and have changed the risk weightings for collateral. The Fed also exempted Citicorp, JP Morgan Chase and Bank of America from its limit on how much its banking unit could lend to its broker-dealer. The Fed provided the exemption because in its words, it was in “in the public’s interest”. This is an exemption of section 23a of the Federal Reserve Act.

The combination of actions has provided significant liquidity to the market and has been the key to the growing stabilization of the money markets. These large banks are some of the key players in the commercial paper market through their dealing and the providing of back-stop credit. Of course, there is the higher rate paid on the discount borrowing, but this is a small penalty relative to the overall benefit granted by the Fed.

Was this good policy? It clearly had the intended effect without forcing the Fed to lower overall interest rates. Theory states that lending standards and providing credit are more important than monetary policy for fixing a credit crunch. In the short-run, this was a deft course of action. The amount of risky loans exceeds the capital base of the banks, so support was needed, but this does not help the borrowers in the declining real estate market or the buyers of CDO. They will have to take their lumps. There are responsibilities but also privileges with being a bank.