Steel Urges Caution on Expanding Safety Net for Banks

By Rebecca Christie

July 5 (Bloomberg) -- U.S. Treasury Undersecretary Robert Steel urged caution when it comes to expanding the federal safety net to financial firms that don't take consumer deposits.

``I think to pull too many other institutions into that arena is a mistake,'' Steel said today during a panel discussion at an Aspen Institute conference in Colorado.

The remarks illustrate Treasury concerns about any regulation that might encourage reckless behavior as it considers proposals that would allow for an orderly dissolution of non-deposit taking financial firms that run into trouble.

Treasury Secretary Henry Paulson, in a speech earlier this week in London, called for regulatory changes in the U.S. that would allow financial firms to go out of business without threatening market stability. He identified a legal gap that leaves unspecified how to deal with failures of companies that don't take deposits, such as investment banks.

Federal Deposit Insurance Corp. Chairman Sheila Bair has urged that an agency be given power to take over and liquidate investment banks in an orderly manner. The FDIC has that power over lenders whose deposits it insures.

``If we over-prescribe regulation, we're going to reduce market discipline, which has the moral-hazard effect of encouraging people to take risk because they think they'll be bailed out,'' Steel said today.

U.S. regulators and legislators are debating plans to alleviate the yearlong credit crisis that has caused $402 billion of writedowns and credit losses worldwide. Paulson has proposed giving the Federal Reserve broader powers as a ``macro- stability regulator.''

House Testimony

Paulson and Fed Chairman Ben S. Bernanke are scheduled to testify July 10 before the House Financial Services Committee on financial-market regulation. The two officials will also respond to lawmakers' questions about the Fed's decision in March to agree to take on about $30 billion in illiquid Bear Stearns Cos. debt and open lending to investment banks.

Other speakers on today's panel said regulators should be careful about spelling out what types of institutions they will bail out and when.

``It is a good idea to have it be really unclear as to whether the Fed is going to save something or not,'' said William Mayer, who was CEO of First Boston until 1990 and is now a partner at Park Avenue Equity Partners in New York. ``The worst thing we could do is say here are the commandments, and right here is where we stop. I don't believe you'd want to do that.''

`Uneven' Progress

Steel said he expects financial markets to make ``uneven'' progress as they recover from the subprime mortgage crisis.

``My instinct is that while we'll continue to make progress from here, that not everything is functioning normally, it'll be uneven,'' he said.

Steel said so-called monoline insurance companies, which expanded their traditional business of underwriting municipal bonds to include more complex securities, underestimated the risk associated with structured credit products.

``They basically sold insurance at what looks to be too cheap a price,'' Steel said. ``The jury isn't completely out on this and the monoline insurance companies still have positive cash flow, and they're going into, basically pulling off the road and letting this unwind.''

To contact the reporters on this story: Rebecca Christie in Aspen, Colorado at Rchristie4@bloomberg.net;