MNI EXCLUSIVE: Fed Worried For Banks If Slump Prolonged

--Growing Fed Fears For Financial System

--Former Officials Tell MNI They Fear Bailouts

By Pedro Nicolaci da Costa

     WASHINGTON(MNI) - Federal Reserve officials are increasingly worried large

banks that have thus far weathered the Covid-19 crisis will run into trouble if

the economic slump proves deeper or more prolonged than expected, perhaps

requiring a new round of bailouts.

     Interviews with several current and former top policymakers suggest growing

concern about the stability of a financial system that the Fed has touted as

being in substantially stronger shape than before the 2008 crisis. Two former

senior officials told MNI they feared U.S. banks were heading for bailouts.

     In particular, policymakers fear large banks might retrench lending further

in coming months even as the economy begins to recover, as cascading corporate

bankruptcies put a heavy dent on Wall Street balance sheets.

     Minneapolis Fed President Neel Kashkari favors forcing banks to halt

dividend payments in order to preserve capital.

     "Large banks can inoculate themselves from the Covid crisis by halting

their dividends and raising equity capital," he told MNI.

     "They should do so now, because the longer this crisis goes on, the more

losses will roll up into the banking sector."

     --FINANCIAL STABILITY RISKS

     Kashkari's proposal has thus far failed to prosper at the Fed. But he is

not the only central banker to flag rising financial stability concerns.

     Fed Governor Lael Brainard has consistently opposed the Fed's decision to

water down a key measure of bank capital that was finally passed in May, arguing

it was "imprudent to reduce the loss absorbing capital at the core of the system

at this point in the cycle, when large banks are internationally competitive,

and payouts have been exceeding earnings."

     Minutes from the Fed's April meeting said a number of FOMC participants

"commented on potential risks to financial stability."

     Furthermore, Fed officials fretted banks might "come under greater stress,

particularly if adverse scenarios for the spread of the pandemic and economic

activity were realized."

     The minutes said "a number of participants emphasized that regulators

should encourage banks to prepare for possible downside scenarios by further

limiting payouts to shareholders, thereby preserving loss-absorbing capital."

     What appears to be a growing consensus already has the broad backing of

former top bank regulators who oversaw the management of the 2008 debacle and

its aftermath.

     "I can only assume the Fed is planning on bailing them out because

otherwise it makes no sense why are they letting them weaken the capital ratio,"

Sheila Bair, former head of the Federal Deposit Insurance Corporation, told MNI.

     The problem is that "even if they're bailed out, they're not going to be

lending," she said. "We're already seeing credit contract. It's going to be

quite severe."

     --BAILOUTS

     Thomas Hoenig, ex-Kansas City Fed chief and former FDIC vice chair, also

worries that the largest U.S. banks might eventually require bailouts of some

kind.

     "If they continue to pay dividends and their balance sheet is weak, you are

risking the government having to bail them out," Hoenig told MNI. "It's a real

concern, not speculation--it actually happened" in the 2008 financial crisis.

     Treasury and the Fed would not allow a major financial institution to go

under despite reform legislation giving them the power to do so, he said.

"They're still too big to fail. They're even bigger now."

     The Fed's minutes spell out how the downward spiral might take hold.

"Participants saw risks to banks and some other financial institutions as

exacerbated by high levels of indebtedness among nonfinancial corporations that

prevailed before the pandemic; this indebtedness increased these firms' risk of

insolvency."

     The Fed's next round of stress tests is due for release in late June. But

the hypothetical 'stress' scenarios, outlined in February, have already been

blown out of the water. The "severely adverse" scenario envisioned a recession

with a jump in the jobless rate to 10%, the Great Recession peak from October of

2009. As of April, the official jobless rate had already surged to 14.7% and is

widely believed to already be effectively above 20%.

     IMF Managing Director Kristalina Georgieva last week called on central

banks to update stress tests "to take into account the increased likelihood of

more adverse economic scenarios caused by the pandemic."

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com

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