Bloomberg: [FDIC chair Sheila] Bair, in a letter to lawmakers released today, endorsed a proposal that was added last week to the regulatory overhaul legislation making its way through the House Financial Services Committee. It would require secured creditors, like repurchase agreement lenders and the Federal Home Loan Bank system, to bear losses of as much as 20 percent to cover the costs of a systemically significant bank failure.
In addition to finding a supposed way to cover costs of winding down a too-big-to-fail institution (and possibly all banks), this portion of the financial overhaul legislation will have some other consequences:
1. It will make it significantly more expensive for these institutions to borrow funds even if they post treasuries as collateral.
2. Any negative news about a specific institution or the financial system as a whole will get lenders running for the fences forcing rapid unwinds. This will make Lehman look like a gradual process.
3. It may destroy the repo market. Repo is used by money market funds, corporations, pensions, etc. to place funds on a secured basis (taking in collateral). As an institution if you have short-term cash and you don't want to deposit it with a bank (unsecured), your only option is to lend it to a bank on a secured basis via repo (taking in treasuries as collateral for example). If this option is taken away, institutions will need an alternative such as the ability to deposit cash with the Fed.
4. This will give foreign banks an unfair advantage by funneling repo lending (secured deposits) to non-US banks, making it cheaper for those banks to fund themselves.
5. US banks will try to get around these laws by creating off-shore financing vehicles that are not subject to US banking legislation, making banking supervision that much more difficult.
As we discussed before, knee-jerk reaction regulation is not always the answer, but in this case could spell an absolute disaster for the US financial system. It behooves the US legislators to slow down their political posturing and try to understand how the finacial system actually works in practice.