Out of the Frying Pan

And into the line of fire of those keen to constrain Wall Street's free-wheeling ways.

“The worst is behind us,” proclaimed Dick Fuld, Lehman Brothers’ boss, in April. If only. Although the overall financial system may be safer, thanks to extraordinary central-bank interventions before and just after the rescue of Bear Stearns, America’s investment banks still make investors nervous, not least in the market that puts a price on the risk of default. The longer this goes on, the more onlookers are tempted to conclude that Wall Street’s business model is broken. With tougher regulation on the cards, this crisis may, they fear, be less a cyclical slump than the start of an era of less risk-taking and lower returns — in effect, the neutering of Wall Street’s finest.

All the investment banks have taken a thumping this year, but Lehman looks the most vulnerable, as it did just after Bear’s near-implosion in March. Despite putting itself on a firmer footing by raising capital, it still has more than $60 billion of hard-to-sell securities. Its hedging attempts have gone awry, leaving the bank facing its first quarterly loss as a public company when it reports in mid-June. Lehman’s shares tumbled this week to a five-year low after its debt was downgraded, amid reports that it is looking for a deep-pocketed partner. This prompted Lehman to rush out the news that its liquidity position had risen to “well above” $40 billion. It also said that it had not needed to borrow from the Federal Reserve since mid-April.

This financing window was opened to investment banks the day after JPMorgan Chase bought Bear—the first time non-deposit-takers have had access to central-bank money since the 1930s. It means that, although doubts about Lehman’s health linger, it is unlikely to run out of short-term funds. Even if the window is shut in September as planned (most bankers assume it will be kept ajar), no one doubts that the investment banks are now considered too systemically important to fail, thanks to their labyrinthine derivatives books.

They all accept the inevitability of greater scrutiny in exchange for acquiring a lender of last resort. Bankers say Fed officials are checking their books much more closely than their Securities and Exchange Commission supervisors ever did.

Commercial banks argue that investment banks should now face the same capital constraints as they do, because of the Fed window. The strength of opposition to this varies: Lehman seems prepared to accept tight shackles, whereas more self-confident firms, such as Goldman Sachs, believe they deserve less regulation because they are funded in wholesale markets, not by government-guaranteed deposits. “[Goldman's] approach is still ‘Screw you, don’t hold us back. We’re the world’s best traders’,” says one rival.

With the situation still fluid, there is plenty of scope for lobbying against rules that could hurt profits—though banks say they are not yet at that point. Sheila Bair, head of the Federal Deposit Insurance Corporation, has come out in favour of tighter oversight of capital and risk management. Ben Bernanke, the Fed’s chairman, seems to be leaning in that direction. But there is, as yet, no consensus. It is not even clear whether the preference is for firm rules or general guidelines. Congress is unlikely to debate an overhaul of financial regulation until next year, after the election.

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