Economics: Federal Reserve Rules Led Small Banks to Big Risks

Back to 2005 ...

The Federal Reserve Board, chastised for regulatory inaction that contributed to the subprime mortgage meltdown, also missed a chance to prevent much of the financial chaos ravaging hundreds of small and midsize banks.

In early 2005, when the housing market was overheated and economic danger signs were in the air, the Fed had an opportunity to put a damper on risk-taking among banks, especially those that had long been bedrocks of smaller cities and towns across the country.

But the Fed rejected calls from one of the nation's top banking regulators, a professional accounting board and the Fed's own staff for curbs on the banks' use of special debt securities to raise capital that was allowing them to mushroom in size.

Then-Chairman Alan Greenspan and the other six Fed governors voted unanimously to reaffirm a 9-year-old rule allowing liberal use of what are called trust-preferred securities.

This was like a magic bullet for community banks that had few ways to raise capital without issuing more common stock and diluting their share price. The Fed allowed the banks to account for the securities in a way that left them free to borrow and lend in amounts 10 times or more than the value of the securities being issued.

Data emerging from the carnage of collapsed and teetering banks leave little doubt that the Fed rule, and regulators' failure to adequately police the issuance of these securities, created big cracks in the already shaky foundations of the nation's banking system.

For more, see Federal Reserve Rules Led Small Banks to Big Risks by Greg Gordon and Kevin G. Hall, December 23, 2010 at CharlotteObserver.com.