Visiting Scholar Allan H. Meltzer

Only in the weird world of Washington are mistakes rewarded with major new responsibilities. After mismanaging both housing loans and the dot-com mess, the Federal Reserve may now become responsible for supervising investment banks.

The proposal by Treasury Secretary Hank Paulson to do so could lead investment banks to accept more risk, because they will be able to hide some of their mistakes by borrowing from Federal Reserve banks. This is cause for concern in itself. What's more, most of the proposal is unnecessary.

Since investment banks mark their portfolio to market every night, all Congress has to do to keep them in line is set a minimum capital standard. If an investment bank is unable to borrow enough to balance daily with its capital intact, it should become subject to the same Federal Deposit Insurance Corporation Improvement Act (FDICIA) rules that apply to commercial banks. These require reduction or elimination of dividend payments when capital is impaired, followed by a temporary takeover by a regulator if capital continues to fall. Management would be replaced and stockholders would bear the losses. This rule goes a long way to discourage excessive risk-taking and moral hazard.

These new rules for investment banks would take effect when markets return to normal. 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.

History shows that the Federal Reserve is a poor supervisor and regulator. The Fed's Board ignored warnings about the risky housing loans that banks were keeping off their balance sheets. This costly mistake is only the most recent of many supervisory failures.

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. To escape the ceiling rates mandated by regulators, businesses moved some of their borrowing abroad, and consumers moved deposits from regulated banks and thrifts to unregulated money-market funds. The Fed watched. Its board discussed the issue many times, but always found a reason to delay. As a result, taxpayers later paid $150 billion to cover the losses, and most of the savings-and-loan industry disappeared.

During the 1980s Latin American debt crisis, the Fed worked with the International Monetary Fund to hide losses to banks. This mistaken policy continued until management at Citicorp chose to write off its losses. Other banks followed. Later the Treasury negotiated a reduction in the debt and an end to the crisis.

Over the years the Fed has shown reluctance to close failing banks, keeping some open even after all their bank capital was gone. The Federal Deposit Insurance Corporation paid for the losses. Congress ended this lax supervision by passing the FDICIA in 1991. The law now requires regulators to act before all the capital or equity has been lost.

In its 95-year history, the Fed has never made a clear statement of its policy for dealing with failures. Sometimes it offered assistance to keep the bank or investment bank afloat. Other times it closed the institution. Troubled institutions have no way to know in advance whether they will be saved or strangled. The absence of a clear policy statement increases uncertainty and encourages problem institutions to demand loans and assistance. Large banks ask Congress to pressure the regulators. Taxpayers pay for the mistakes.

So what can taxpayers expect from an increase in the Fed's discretionary authority over investment banks? The likely answer is rescues, delays and lax supervision--followed by taxpayer-financed bailouts. Throughout its postwar history, the Fed has responded to the interests of large banks and Congress, not the public.

Investment banks don't need the Fed to regulate them. Some clear rules on capitalization would suffice.

Allan H. Meltzer is a visiting scholar at AEI.