WASHINGTON - The privilege of borrowing cash from the discount window is likely to carry the burden of stricter supervision for investment banks.
At a minimum, the Securities and Exchange Commission's relatively cursory oversight is likely to be replaced with the Federal Reserve Board's fine-tooth-comb approach.
"Now that large investment banks are allowed to step up to the window, some greater degree of regulation should be examined," Sen. Charles Schumer, the chairman of the Joint Economic Committee and a member of the Senate Banking Committee, said on a conference call with reporters Monday.
The New York Democrat raised doubts about the entire structure of the financial services system.
"Regulation is fractured and based on a financial system that doesn't work any longer," Schumer said. "There should be some combination of regulators or they should at least act in greater harmony."
He was seconded by Senate Banking Committee Chairman Chris Dodd, D-Conn., who said increased Fed oversight should "absolutely" be part of any deal that gives investment banks access to the discount window.
"Look, that's got to come with this," he said.
A source at a large banking company said such a change is a matter of fairness. "It's bad enough that banks are 'too big to fail' - at least they are paying something for that status. The investment banks literally have a free ride. They have all of the benefits and none of the burden."
The source, who did not want to be identified for fear of angering more senior executives or the company's regulators, predicted that the congressional reaction would rival the fallout from the savings and loan crisis, when major laws were enacted in 1989 and 1991. "I assume this is going to be every bit as big."
Schumer and Dodd, along with Senate Majority Leader Harry Reid, D-Nev., said Monday that the Fed's move was more proof that a housing rescue plan was necessary.
Dodd said the plan he is drafting with House Financial Services Committee chairman Barney Frank, D-Mass., to expand the Federal Housing Administration's guarantee on loans is gaining traction with the Bush administration.
"There is a greater receptivity to this idea than there was 48 hours ago," Dodd said. "So we are going to continue pushing it."
Treasury Secretary Henry Paulson appeared defensive of the Fed's actions Monday, saying they did not constitute a bailout, because shareholders took a substantial loss.
"In terms of moral hazard - look at what happened to Bear Stearns shareholders," he told reporters on the White House lawn.
"What I'm really focused on are things that can be done quickly that make a difference," he said. "While there are some interesting ideas up on the Hill, we still don't have FHA modernization."
The FHA bill has passed both houses of Congress, but lawmakers have not settled differences between the House and Senate versions.
Some industry observers argued Monday that a massive overhaul to the system is not necessary.
Wayne Abernathy, a former Treasury official and now the American Bankers Association's executive vice president of financial institutions policy, said the Fed had taken appropriate steps to ensure the collateral it receives from investment banks was not risky.
"The Fed needs to do whatever they need to do to have the kind of confidence and collateral they are receiving - I don't think that means you need to change the regulatory system," he said. "I would feel concerned if they were opening up the window willy nilly, but I don't think that's what they are doing."
Coincidentally, the Treasury Department is overdue to deliver a report on recommendations for revamping financial market supervision. Paulson announced that plan in June, and the report was expected to be made public early last month. Now the department says it expects to unveil the report any time.
The Treasury was widely expected to propose combining the Office of the Comptroller of the Currency and the Office of Thrift Supervision. But in light of the tremendous upheaval that led Bear Stearns to sell itself to JPMorgan, the administration may come out with something bolder.
OCC and Fed officials were not doing interviews on this topic Monday, but recent comments indicate bank regulators would back tighter oversight of investment banks.
Fed vice chairman Donald Kohn argued this month that the central bank should not open its discount window to investment banks without the intimate knowledge gathered by examining an institution. Such a move "could carry some very major costs," he said
Commercial banks "have access to the discount window, but the quid pro quo" is regulation, Kohn testified before the Senate Banking Committee on March 4. "You have constricted their activities in a number of ways relative to investment banks."
Comptroller of the Currency John Dugan agreed with that assessment. "You have to be very careful about giving out the government's credit, except to institutions that you really pay very close supervisory attention to," he testified the same day.
Most outside observers said the odds of a regulatory overhaul have improved significantly as a result of the Bear Stearns rescue and the Fed's decision to let investment banks borrow from the discount window. On Sunday the central bank lowered the window rate by 25 basis points, to 3.25%, narrowing its premium to federal funds borrowing to a quarter of a percentage point.
"There is no question that investment banks will be better regulated in the future," said Chris Low, chief economist for First Horizon National Corp.'s FTN Financial. "We will see a significant overhaul of the entire regulatory process."
Stacy Kaper and Steven Sloan contributed to this story.