News Detail

Allan Meltzer Tells Congressional Subcommittee That Appropriate Regulatory Change Must Protect the Public, Not Bankers

Author:Mark D. Burd 412-268-3486

Release Date: Jul 10, 2009

           WASHINGTON, D.C. — Acknowledging that regulatory reform is necessary and has been long delayed, Tepper School Professor Allan Meltzer told the members of the House Subcommittee on Monetary Policy that “appropriate” change must protect the public, not bankers. During the testimony before the subcommittee, which is attached to the House Committee on Financial Services, Meltzer offered an appraisal of the Obama administration’s proposed  regulatory changes and offered a five-step alternative proposal aimed at eliminating or reducing the cost of financial failures to the taxpayers.  

             Meltzer, who is also a historian of U.S. monetary policy and author of the definitive History of the Federal Reserve, Volumes I & II, highlighted the Federal Reserve’s shortcomings in predicting or preventing previous financial crises.

             “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,” said Meltzer. “We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $ 150 billion. AIG, Fannie and Freddie will be much more costly.”

             Referring to action as “long overdue,” Meltzer said  the Obama proposal recognizes the critical need to define and communicate a clear policy for how the central bank  will act when confronted by the crisis of financial institutions within the system. However, Meltzer says the policy is incomplete, and called for a clear definition of “systemic risk,” adding that without this element of clarity, any proposal would likely prompt frequent controversy.

            “In its 96-year history, the Federal Reserve has never announced a lender-of-last-resort policy,” notes Meltzer, adding that “announcing and following a policy would alert financial institutions to the Fed’s expected actions and might reduce pressures on Congress to aid failing entities.”

            In his alternative proposal, Meltzer suggested that bankers should bear more of the burden of responsibility for losses, adding, “The administration’s proposal does the opposite by making the Federal Reserve responsible for systemic risk and the public responsible for losses.”

           The five initial steps of his alternative proposal included: 

• Ending the concept of  “too big to fail” by requiring all financial institutions to increase capital in proportion to their increase in size of assets.
• Requiring the Federal Reserve to follow a pre-announced rule for serving as lender-of-last-resort.
• Recognizing that regulation is an ineffective way to change behavior because markets will circumvent burdensome regulations.
• Recognizing that regulators do not anticipate the incentives induced by their regulations.
• Either extending the Federal Deposit Insurance Corporation Improvement Act (FDICIA) to include holding companies or subjecting financial holding companies to bankruptcy law.

            “Three principles should be borne in mind,” concluded Meltzer. “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. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy and the public. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public.”

             Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He also is a visiting scholar at the American Enterprise Institute.