Allan H. Meltzer
Wall Street Journal
July 16, 2008
Only in the weird world of Washington are mistakes rewarded with major
new responsibilities. After mismanaging both housing loans and the
dot-com mess, the Federal Reserve may now become responsible for
supervising investment banks.
The proposal by Treasury Secretary Hank Paulson to do so could lead
investment banks to accept more risk, because they will be able to hide
some of their mistakes by borrowing from Federal Reserve banks. This is
cause for concern in itself. What's more, most of the proposal is
unnecessary.
Since investment banks mark their portfolio to market every night, all
Congress has to do to keep them in line is set a minimum capital
standard. If an investment bank is unable to borrow enough to balance
daily with its capital intact, it should become subject to the same
Federal Deposit Insurance Corporation Improvement Act (FDICIA) rules
that apply to commercial banks. These require reduction or elimination
of dividend payments when capital is impaired, followed by a temporary
takeover by a regulator if capital continues to fall. Management would
be replaced and stockholders would bear the losses. This rule goes a
long way to discourage excessive risk-taking and moral hazard.
These new rules for investment banks would take effect when markets
return to normal. At that time, the Fed should end lending to
investment banks altogether, and begin to repair the damage to its
balance sheet by greatly reducing holdings of long-term loans.
History shows that the Federal Reserve is a poor supervisor and
regulator. The Fed's Board ignored warnings about the risky housing
loans that banks were keeping off their balance sheets. This costly
mistake is only the most recent of many supervisory failures.
During the 1960s and '70s, Fed governors discussed the problems caused
by the combination of Regulation Q – which restricted the
interest rate that banks and thrifts could pay depositors – and
inflation. To escape the ceiling rates mandated by regulators,
businesses moved some of their borrowing abroad, and consumers moved
deposits from regulated banks and thrifts to unregulated money-market
funds. The Fed watched. Its board discussed the issue many times, but
always found a reason to delay. As a result, taxpayers later paid $150
billion to cover the losses, and most of the savings-and-loan industry
disappeared.
During the 1980s Latin American debt crisis, the Fed worked with the
International Monetary Fund to hide losses to banks. This mistaken
policy continued until management at Citicorp chose to write off its
losses. Other banks followed. Later the Treasury negotiated a reduction
in the debt and an end to the crisis.
Over the years the Fed has shown reluctance to close failing banks,
keeping some open even after all their bank capital was gone. The
Federal Deposit Insurance Corporation paid for the losses. Congress
ended this lax supervision by passing the FDICIA in 1991. The law now
requires regulators to act before all the capital or equity has been
lost.
In its 95-year history, the Fed has never made a clear statement of its
policy for dealing with failures. Sometimes it offered assistance to
keep the bank or investment bank afloat. Other times it closed the
institution. Troubled institutions have no way to know in advance
whether they will be saved or strangled. The absence of a clear policy
statement increases uncertainty and encourages problem institutions to
demand loans and assistance. Large banks ask Congress to pressure the
regulators. Taxpayers pay for the mistakes.
So what can taxpayers expect from an increase in the Fed's
discretionary authority over investment banks? The likely answer is
rescues, delays and lax supervision – followed by
taxpayer-financed bailouts. Throughout its postwar history, the Fed has
responded to the interests of large banks and Congress, not the public.
Investment banks don't need the Fed to regulate them. Some clear rules on capitalization would suffice.
Mr. Meltzer is university
professor of economics at Carnegie Mellon University, visiting scholar
at the American Enterprise Institute and author of "A History of the
Federal Reserve" (University of Chicago Press).
