Update of Measures Taken to Create Financial Stability

For additional resources on the Emergency Economic Stabilization Act, click here.

By: KAREN L. GRANDSTRAND & KARLA L. REYERSON

October 13, 2008

The week following the historic passage of the Emergency Economic Stabilization Act of 2008 (EESA) on October 3, 2008 (see President Bush Signs the Emergency Economic Stabilization Act of 2008), saw additional substantial losses on Wall Street and continuing efforts by the government to turn things around.

Federal Reserve Begins Paying Interest on Reserve Balances

On October 6, 2008, the Board of Governors of the Federal Reserve System (the Federal Reserve) announced that it was modifying Regulation D to allow the Federal Reserve to begin paying interest on the funds banks hold in Reserve Banks to satisfy reserve requirements and on any excess reserves. The Financial Services Regulatory Relief Act of 2006 provided for this measure to take effect October 11, 2011; however, EESA changed the effective date to October 1, 2008.

The amount of interest paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee (FOMC) over each reserve maintenance period less 10 basis points. The rate paid on excess balances will be the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on reserve balances essentially eliminates the opportunity cost of holding reserves, while paying interest on excess balances is intended to provide liquidity and lessen the incentive for institutions to trade balances in the market at rates much below the rate paid on the excess reserve balances.

The Reserve Banks began paying interest on reserves on October 9, 2008; however, financial institutions may comment on the changes to Regulation D until November 21, 2008.

Federal Reserve to Purchase Commercial Paper

The Federal Reserve indicated on October 7, 2008, that it will begin purchasing an unlimited amount of commercial paper directly from issuers. The Federal Reserve intends to purchase three-month unsecured and asset-backed commercial paper directly from issuers as part of its new Commercial Paper Funding Facility (CPFF). This action is designed to provide liquidity to the commercial paper market, which has been under “considerable strain in recent weeks,” according to the Federal Reserve. The program will be funded by a deposit of the Treasury into the Federal Reserve Bank of New York and by fees charged to borrowers. The Federal Reserve thought it would have the facility running within days. The program is set to expire April 30, 2009, but the deadline could be extended if necessary.

The CPFF is the latest of several actions the Federal Reserve has taken to alleviate the liquidity crisis. Other programs include cash and Treasury auctions, loans to investment banks, and a money market mutual fund guarantee program. As part of this larger effort, on October 6 the Federal Reserve also increased its 28-day and 84-day Term Auction Facility auctions to $150 billion each, beginning with the 84-day auction set for October 13, 2008. November auctions were also increased to $150 billion.

Federal Reserve Rate Cut

On Wednesday, October 8, 2008, the Federal Reserve, along with six other central banks around the world, announced a coordinated interest rate cut. The FOMC lowered its target for the federal funds rate by 50 basis points to 1.5%. It also lowered its discount rate 50 basis points to 1.75%. The Federal Reserve indicated it took this step in light of evidence of weakening economic activity and reductions in inflationary pressures.

Treasury Begins Implementation of TARP

The U.S. Treasury Department (the Treasury) began the process of implementing the provisions set forth in EESA almost immediately after its passage. First, on October 6 it appointed Neel Kashkari as the Interim Assistant Secretary of the Treasury for Financial Stability. Kashkari will head up the Office of Financial Stability and the Troubled Assets Relief Program (TARP), both of which were created under EESA. Mr. Kashkari, a former Goldman, Sachs & Co. executive, joined the Treasury in 2006 as Senior Advisor to Secretary Paulson. He is currently Assistant Secretary of the Treasury for International Economics and Development, a position he will keep, although his International Affairs responsibilities will be transferred to someone else.

Also on October 6, 2008, the Treasury posted three solicitations for financial agents to provide services needed to implement various parts of TARP. Specifically, the Treasury sought financial institutions to provide custodian, accounting, auction management, and other infrastructure services; securities asset management services; and whole loan asset management services. The deadline to apply for these positions was October 8, 2008.

In order to be eligible, a financial institution could not have any delinquent debts to the government, current enforcement actions, or be the subject of any regulatory investigations. In addition, there were minimum qualifications for the specific services to be provided. For example, those interested in providing whole loan asset management services were required to have been in the business of providing such services for the last five years and be managing, or capable of managing, a portfolio of at least $25 billion in mortgage loans. Future solicitations and information regarding contracts awarded will be posted on www.fedbizopps.gov.

Treasury Considers Taking Equity Interest in Banks

During the week following EESA’s passage, the Treasury indicated it is considering using part of the $700 billion received under EESA to inject capital directly into financial institutions. The Treasury indicated it would do this by purchasing nonvoting equity interests in institutions that expressed interest in such a program, though the program would be aimed at healthy institutions only. Such a program would be designed to encourage institutions to raise additional private capital in addition to the public capital the Treasury would provide. No firm date was disclosed for commencement of the equity program.

Regulators Release Proposal to Lower Risk Weights on Fannie/Freddie Debt

On October 7, 2008, the federal banking regulators issued a proposal that would allow financial institutions holding debt of Fannie Mae or Freddie Mac to lower the risk weighting for such debt from 20 percent to 10 percent, thereby reducing the capital requirements for banks holding such debt. The 10 percent risk weight would include both senior and subordinated debt, but not equity holdings. EESA does allow financial institutions to treat any gains or losses on the sale or exchange of preferred stock of Fannie or Freddie as ordinary income or losses.

FDIC Proposes Doubling Insurance Premiums

On October 7, 2008, the FDIC proposed doubling the premiums that depository institutions pay for deposit insurance in order to replenish the Deposit Insurance Fund within five years to a reserve ratio of 1.25%. Under the proposal, the assessment rate schedule would be raised by seven basis points beginning January 1, 2009. The proposal would also change the factors used to calculate the premiums. Factors that may raise premiums would include excessive use of brokered deposits tied to rapid growth and excessive use of secured liabilities. Institutions could receive a rate reduction by holding long-term unsecured debt or, for small institutions, high levels of  Tier 1 capital. Comments on the proposal are due no later than 30 days after publication in the Federal Register.

As we prepared this update for publication, the Treasury announced additional details regarding a Capital Purchase Program whereby the Treasury will purchase senior preferred shares of eligible banks that wish to participate in the program. At the same time, the FDIC announced a new Temporary Liquidity Guarantee Program which will, for a limited time, cover new senior unsecured debt issued by banks and provide full coverage of noninterest-bearing deposit transaction accounts, regardless of dollar amount. We will provide additional details related to these and other new developments in our next update.