Can the Fed roll another pair of sixes in the next crisis?
The central bank made trillions of dollars of emergency loans (see chart, right) during the financial meltdown of 2008 and 2009, without suffering losses. Along the way it propped up hundreds of borrowers, from Citigroup (C) and Goldman Sachs (GS) to the U.S. branches of the Bank of China and Arab Banking Corp., which is backed by Libya.
But critics warn that the central bank may not be so lucky next time. As much as the Fed likes posing as financial superman, central bankers have no power to see through the black box that lies at the center of global banks they don’t regulate.
That could leave the Fed flying blind into big risks as it lends to stricken global banks in the next crisis, which — hello, Europe! — could be coming soon.
“Lending to zombies is a little like the halfcourt shot in basketball,” said Ed Kane, a professor at Boston College. “It’s nice when it pays off, but it’s not always going to go in.”
A Fed spokeswoman didn’t return a call seeking comment, but the central bank’s defenders would surely say it protects taxpayers by lending only against collateral that can be sold in the event of a default.
Yet the sheer size of some of the loans the Fed made during the 2008 crisis gives pause. Dexia of Belgium and Depfa of Germany, two bailed-out European institutions, took $50 billion in loans on a single day in October 2008 when the interbank lending market seized up.
You might justify those loans by pointing to those giant banks’ importance to the financial system, of course. But how then to justify $5 billion in loans to Arab Banking, the Bahrain-based lender that at the time was backed by Libya and the sovereign wealth funds of Abu Dhabi and Kuwait?
And of course, the notion that the Fed lends only to sound banks is undermined somewhat by the observation that it lent during the crisis to at least 100 banks that later failed.
“The Fed stepped outside its core mandate, and it’s clear from those sorts of decisions that they acted in an ad hoc fashion,” said Mark T. Williams, a former Fed bank examiner who teaches finance at Boston University. “The system hinges on people having confidence in the top of the house, but we can see from the crisis that there are some leaks in the roof.”
Indeed, regulators have a checkered record when it comes to assessing the riskiness of their own banks, as we saw here during the housing bubble. We are seeing that again now in Ireland, where the cost of bank bailouts rises almost as regularly as the pump price of gasoline.
Fed backers might well respond that the 2008 meltdown was a devastating, once-in-a-lifetime storm that called for a pull-out-all-stops response. They might note as well that U.S. branches of foreign banks are by law eligible to borrow at the discount window in times of distress. What sort of policy would turn down borrowers who presented good collateral just because their parent company is based overseas?
True enough. But the scenario playing out now could turn out even worse than the 2008 crisis, because stretched countries like Ireland don’t have the fiscal firepower to save their banks again. Everyone assumes European central bankers would step in to prevent a meltdown, but the political opposition to bailouts is intense and who knows how long it might take to build a consensus to act?
All this is more reason for the Fed and the other major central banks – led by the European Central Bank, which has the makings of a banking crisis on its hands now in Ireland and potentially Spain – to do more to share information about the true condition of the banks under their purview, lest they blow up again.
“If the Fed has global responsibilities, it will need global transparency to manage risk,” said Andrew Barber, who runs investment adviser Waverly Advisors in Corning, N.Y.
The Fed’s setup right now, Barber adds, is “like a blind spot in your vision when you’re driving.” Not what Bernanke & Co. need, to say the least.
Also on Fortune.com:
Follow me on Twitter @ColinCBarr.
