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--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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