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Published: November 25, 2008


The Thought Leader Interview: Allan Meltzer

My concern is that instead of the Fed making its role the protection of the public, it will make its role the protection of the bankers. That is hardly what you think of as the public interest. The agreement to open the discount window to nonbank financial institutions and the expansion of the Fed’s regulatory role both stem from pressure from Congress and Wall Street. It’s hard to see how the Fed can routinely respond to that pressure and still be credible. People on Wall Street and in Congress like it, but the public, ultimately, won’t like it. And it’s not a sustainable system. There can’t be a system where the bankers make the profits and the public takes the losses. Sooner or later that system has to change.

Anticipating Big Changes

S+B: You were quoted in an interview several years ago saying that “big changes usually come after there is a crisis or a perceived failure of the old policy that can no longer be denied.”
Isn’t it the truth.

S+B: Are we at that point now?
Absolutely. The question that needs to be asked is, How do we avoid problems like these in the future? I’ve indicated what I think should not happen — ex­panding the Fed’s regulatory role. Instead, I think there are three steps that would go a long way toward correcting the problems.

The first would be to make sure that all financial institutions are subject to minimum capital requirements and to the Federal Deposit Insurance Corporation Improvement Act [FDICIA], in the same way that commercial banks have been. This has already happened for the big New York investment banks that have changed recently into bank holding companies. Congress enacted FDICIA in 1991 to force the regulators to shut down failing banks before they lose all their capital. These kinds of rules have not been considered necessary for in­vestment banks in the past — partly because, as I said, there haven’t been many failures. There probably won’t be that many failures going forward either, but capital requirements and the FDICIA procedures will reduce the prospect that there will be. That way, if the capital of one of the remaining investment banks gets to a low enough point relative to assets, we can stop it from paying dividends, get rid of the management, and push the losses on to the shareholders.

The second step is for the Fed to make a clear statement of its policy for dealing with failures. Throughout its history, it has never done that. Sometimes the Fed decides that it has to bail out the bank. Sometimes it decides it can let the bank fail. Sometimes it takes some intermediate step. You could avoid the uncertainty by having a clear and definite rule that is applied to everybody. When Walter Bagehot wrote Lombard Street — his great book on central banking and the lender of last resort function in the 19th century — he didn’t criticize the Bank of England for not doing the right thing. He criticized the Bank of England for not announcing in advance what it was going to do. And that’s where the Fed has failed. It has never said what it wanted to do.

Both of those changes could be made by legislation, and it would be a big change in the regulation of financial markets.

The third thing we need to do is to change the incentives in the markets, and I think that would be best done by the markets and the companies themselves. These institutions need to change their compensation systems so that individual traders are more at risk, and salaries and bonuses are based on perfor­mance over a longer period of time than is the case now — something like basing bonuses on five-year average earnings.

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