A bad habit will usually stay a habit as long as the money is there to fuel it. The Federal Reserve has been making decisions in recent months that are providing serious support for U.S. investment banks. The effectiveness of these hand-outs and incentives is hard to measure, but investors should keep tabs on how these changes could impact the stability the investment banking sector.
If investment banks are continually rewarded for their bad behavior, why would they change?
Opening Line of Credit
The first alarming news was the Fed extending access to the discount window, which is essentially a U.S.-backed line of credit, to investment banks if they fall into a crisis. On one side of the argument, the fear is that investment banks will be more likely to venture into risky investments if they know there will be a safety net to catch them. For others, the line of credit is seen by others as a safety valve for the sake of liquidity and preserving the financial system.
In my opinion without a check or equivalent balance in place, the line of credit could be a bigger risk than the fed should be willing to shoulder. Yes, more stringent balance sheet requirements could also be a positive result of this change, but on a practical level having to pay for items in cash versus knowing in the back of you mind that you have access to credit promotes more responsible behavior.
No Short for You!
Secondly, the Fed is now considering not letting investors, particularly hedge funds short sell the large U.S. investment banks. The idea may have merit, but even if this measure is put into place now, much of the bleeding has already taken place. Over the past year Lehman Brothers (NYSE:LEH) is down 77%. Citigroup (NYSE:C) and Merrill Lynch (NYSE:MER) have each lost nearly 70% of their stock value. Morgan Stanley (NYSE:MS) and Bank of America (NYSE:BAC) have also fallen more than 50% during the same time period. Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) have been the most resilient amongst the group, but they have still fallen more than 20%.
The scene outside of IndyMac bank with customers forming lines to get their money out of the closed bank crystallizes the severity of the credit and debt issues in the U.S. financial system. I have no crystal ball that will tell me the best solution to solve the credit crisis, but looking overseas, banks like Banco Santander (NYSE:STD) have proved that focusing on the basics of accepting deposits and making loans can keep banking institutions out of bad debt related issues.
The Dow Jones Industrial Average dropped below 11,000 earlier this week. Financials continue to be the main focus of the problems in the U.S., but I wonder if it's the individuals in the firms that need more attention. Rules and laws exist to ensure the individuals and organizations keep their promises. The Fed has the unique opportunity to act as either an enabler of risk taking or an enforcer with the power to repair investment banking system.
For further reading, check out our related article The Whens And Whys Of Fed Intervention.