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 / Winter 2008 /Issue 53(originally published by Booz & Company)


The Thought Leader Interview: Allan Meltzer

S+B: What are the risks of the Fed holding a large amount of these types of questionable assets on its balance sheet?
It limits their flexibility; it means there’s less they can do. They can’t sell those assets, so in effect they’ve cut their balance sheet in half, although they still have a big enough portfolio that they can engage in the operations that they want to. Also, it shifts the risk to the taxpayers because not all those assets may be paid when they are due, or even at all. The bigger problem, in my opinion, is the perception — now held by the market and Congress — that the Fed can be pushed around, which is not what a central bank in a well-run country wants to have. It affects its independence, and ultimately its credibility in conducting monetary policy.

The Limits of Regulation

S+B: Before we discuss monetary policy, what’s your view on the Federal Reserve’s emerging role as supervisor of the big Wall Street firms — in addition to the commercial banks that they oversee? MELTZER: I am very concerned with the Fed’s role in regulating these institutions. The Fed is not equipped to do it; it won’t do it well because it doesn’t have a history of being a good regulator. It has a hard time understanding the complicated securities that are involved there.

The Fed did a terrible job, for example, of resolving the Latin American debt problem in the 1980s. The Latin American countries had large bank loans and were paying interest to the banks when the crisis started. When they couldn’t pay, the Fed arranged with the International Monetary Fund [IMF] that the IMF would lend the countries the money, and the money would be paid to the banks to keep the interest payments up to date. As a result, the debt kept getting bigger, the solution receded further into the future, and neither the Fed nor the IMF had any idea about how they were going to end the problem. Finally, in 1987, John Reed, the CEO at Citicorp — the predecessor of Citigroup — decided to write off his institution’s Latin American loans and get back to doing business. And that was the beginning of the end of the problem.

One of the things that gets too little attention is the fact that after 1974, when we had several commercial bank failures here and in Germany, the international reg­ulators got together, and they established the Basel standards for bank capital. The Basel standards, like so much regulation, were written by bureaucrats and lawyers with little thought about the incentives they were creating. It was a familiar circumstance: The lawyers make the rules, and the markets determine how to circumvent them. In this case the rule said that if a bank took on more risk, it had to put up more reserves. To circumvent that rule, the banks didn’t put the risk on their balance sheets. One way they avoided this was by packaging the loans they made into new types of securities that they could sell to other financial institutions.

We went from a system that was not well regulated, but at least was observed, to a system in which no one knew where the risks were. We still don’t know where all of the risks are. Tomorrow we may learn that somebody somewhere has a portfolio of securities that’s now deeply underwater. It’s not a very good system. It doesn’t speak well for the way in which the regulation was conducted.

That’s why I worry that Congress will overrespond to this crisis and put more regulation on the fi­nancial markets than is good for us, so that the markets will move, probably to London. The trading, in particular, will move to London. I think the Sarbanes-Oxley Act certainly was a step in that direction, and that’s a real risk here.

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