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Written by R.D. Norton
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Friday, 31 July 2009 00:00 |
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The current issue of AIER’s Research Reports leads off with Allan Meltzer’s critique of the Obama administration’s proposals for giving the Federal Reserve System a new role in bank regulation. The article reprints testimony Professor Meltzer gave July 9, 2009, before the Subcommittee on Monetary Policy of the House Committee on Financial Services.
Some highlights from the article are offered here:
”I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures.
We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $150 billion. Of course, the Fed did not have responsibility for the thrift industry, but many thrift failures posed a threat to the financial system that the Fed should have tried to mitigate.
In the dot-com crisis of the late 1990s, we know the Federal Reserve was aware of the growing problem, but it did not act until after the crisis occurred.
Free to Fail: Three Principles
First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the cost of failures to society.
Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior.
Third, those that rely on regulation to reduce risk should recall that this is the age of Madoff. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public.
We all know that the Federal Reserve did nothing to prevent the current credit crisis. In 2008, the Fed assisted in salvaging Bear Stearns. This continued the too-big-to-fail (TBTF) policy and increased moral hazard.
Then without warning, the Fed departed from the course it had followed for at least 30 years and allowed Lehman to fail in the midst of widespread financial uncertainty. This was a major error. It deepened and lengthened the current deep recession.
Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Reform should start by increasing a banker’s responsibility for losses. The administration’s proposal does the opposite by making the Federal Reserve responsible for systemic risk.
The administration’s proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake.
If we use our capital to avoid failures instead of promoting growth we sacrifice a socially valuable arrangement—central bank independence. We encourage excessive risk-taking and moral hazard.
I believe there are better alternatives than the administration’s proposal.
First step: End TBTF [Too Big to Fail]. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF is perverse. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur.
Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation.
The lesson is to focus on incentives, not prohibitions. Shifting losses back to the bankers is the most powerful incentive because it changes the risk-return tradeoff that bankers and stockholders see.” This commentary is based on a longer article by Allan Meltzer in the latest issue of Research Reports, available free to AIER subscribers or $2 for non-members. Also in this issue: Pending Changes, Enduring Problems
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by Polina Vlasenko, Research Fellow
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