Tags: investment | banks

Fed Expert: Keep the Fed Away from I-Banks

Tuesday, 29 Jul 2008 11:57 AM

Federal Reserve expert Allan Meltzer says Treasury Secretary Henry Paulson's proposal to allow the Fed to supervise investment banks will mean more rescues, lax supervision, and taxpayer-financed bailouts.

The Federal Reserve mismanaged housing loans, the dot-com bubble, and the earlier savings & loans crisis, says Meltzer, a professor of economics at Carnegie Mellon University, in a recent editorial in The Wall Street Journal.

"Only in the weird world of Washington are mistakes rewarded with major new responsibilities," Meltzer writes.

The Fed's a lousy supervisor and regulator, Meltzer says.

According to Meltzer, the Fed ignored warnings about risky home loans that banks were keeping off their balance sheets, a costly mistake that was only the most recent of its many failures.

Years earlier, he says, it sat on its hands while the S&L crisis unfolded.

"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," he explained.

To escape that rate ceiling, businesses moved borrowing abroad and consumers moved deposits to money market funds. The Fed board frequently talked about the issue but did nothing.

The results? A $150 billion bill to taxpayers and the end of the S&Ls.

The Fed has shown it's reluctant to close failing banks, says Meltzer. It has even kept some open even though they had no capital. Congress put a stop to that in 1991, passing a law requiring regulators to act before all of a bank's capital or equity is gone.

"In its 95-year history, the Fed has never made a clear statement of its policy for dealing with failures," Meltzer states. Sometimes it kept the bank or investment bank afloat. Sometimes it closed them. The companies don't know if they'll be saved.

"Large banks ask Congress to pressure the regulators," he writes. "Taxpayers pay for the mistakes."

Besides being a bad idea, Paulson's proposal is unnecessary, according to Meltzer. Because investment banks mark their portfolio to market every night, all Congress has to do is set a minimum capital standard.

If an investment can't borrow enough to meet that level, it should be subject to the to the same FDIC rules applying to commercial banks.

The investment bank would have to cut or eliminate dividends, and perhaps be temporarily taken over by a regulator. Management would be replaced and stockholders would bear the losses. Those rules would discourage excessive risk taking and moral hazard.

Those rules should take effect when the market returns to normal, Meltzer argues.

"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."

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Federal Reserve expert Allan Meltzer says Treasury Secretary Henry Paulson's proposal to allow the Fed to supervise investment banks will mean more rescues, lax supervision, and taxpayer-financed bailouts.The Federal Reserve mismanaged housing loans, the dot-com bubble, and...
investment,banks
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2008-57-29
Tuesday, 29 Jul 2008 11:57 AM
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