2014 Financial Markets Conference
April 2014
An interview with Allan H. Meltzer, the Allen H. Meltzer University Professor of Political Economy, Carnegie Mellon University's Tepper School of Business, and David Zervos, chief market strategist, Jefferies LLC
Paula Tkac: Hi, I'm Paula Tkac. We are here at the Financial Markets Conference of the Federal Reserve Bank of Atlanta, and I'm talking with Professor Allan Meltzer and Dave Zervos. Welcome.
David Zervos: Thank you.
Allan Meltzer: Thanks for having me.
Tkac: So one of the questions that came up today in the panel session that you both participated in had to do with the formulation of monetary policy and how we think about financial stability. Do you think there's another role for monetary policy in financial stability?
Zervos: The Glass-Steagall Act did a wonderful job of separating out some of the shadow banking side of the commercial bank industry. And I think it was that mixing of commercial and shadow that was not easily seen by the Federal Reserve regulators on an H.8 report that was the ultimate cause of the crisis, and it necessitated the injection of capital into these banks.
But I think on our panel we were discussing, should credit market conditions and financial market conditions be part of the thought process behind the policy reaction function at the Fed? And I think that Allan, and Jeremy [Stein, a member of the Fed Board of Governors], and I all agreed that very tight credit spreads or very wide credit spreads should be part of the thought process as a broad measure of financial conditions, including even as broad as trends in the equity market, trends in the value of the U.S. dollar vis-à-vis its trade-weighted index, and other broad measures of maybe steepness of the yield curve or flatness of the yield curve. All of those things that would go into a traditional financial market conditions index that we've thought about should be somehow incorporated into the monetary policy thinking, and each part plays its own role.
Meltzer: I'm not smart enough to know how to regulate banks, and I don't think that other people are either, and so I am going to leave that to the bankers and make them pay for their mistakes; that's really my idea of financial stability. I don't agree that it's a regulatory matter; I think it's a management matter. You want the bankers to know about the risks. When we went into this 2008 crisis, some of the banks had 1 or 2 percent equity capital, and they made their book capital that they were required to hold by holding bonds, which they insured. So to use the vernacular, "They didn't have any skin in the game." They didn't care about the risks they were taking.
As far as the panel discussion of risk, yes, I think the Fed should pay attention, central banks have to pay attention to asset markets, to credit markets, and all that, and they don't do that, and certainly increasingly they do less of it, and that's a bad thing. But I don't agree that Glass-Steagall was still a good idea. Before they repealed Glass-Steagall, the banks could do just about everything that the investment banks could do, and the investment banks could do almost everything that the banks could do except take deposits, but both of them were financed in overnight markets by CDs [certificates of deposit] and that sort of thing.
Zervos: So I would take a small objection with that, only to the extent that I think the payment system and the potential for a collapse in the payment system by the large clearing banks was really the heart of the crisis.
Meltzer: But let's think about two different scenarios. One is one in which we have a requirement of 15 percent equity capital and a Lehman Brothers is allowed to fail. If the other banks have all that equity capital, there's not going to be a run. The run occurs because when Lehman failed, it set off waves of belief that all the others or many of them were equally liable to fail. That's when the payment system collapsed. If we had 15 percent equity capital and stockholders who were saying, "Hey, what kind of risks are you guys taking with our money?" then we wouldn't have...
Zervos: I think that 15 percent would get you a long way there, Allan, but I'm not sure. I'm not sure that that's the right number.
Meltzer: We can never be sure.
Zervos: What I would say is that by not allowing the payment system banks, the big money center clearing banks to engage in the highly levered activity of short-term lending and repo markets, in addition to the securities trading businesses, that you put a wall between the contagion of Lehman to Morgan Stanley to Goldman Sachs, and if that run takes out a few broker-dealers along the way as it did in the pre-Fed period, it still preserves the State Street Bank of New York/Chase world of where I can pay my electric bill every day. I want to be able to pay my electric bill. I don't need them trading securities with my deposits.
Meltzer: But don't you think that if they held 15 percent equity capital they would be prudent?
Zervos: Maybe. Well, how about I just say, "No, you can't do it." That also is prudent.
Meltzer: I'm not smart enough and I don't think other people are smart enough to be able to know how to do the regulation wisely. So I'm going to leave to the banker the decision about the risk that he wants to take, but I'm going to make him pay for those risks. The mistake we made was to allow him to take the risks and get him out of the position of where he had to pay for them.
Zervos: One hundred percent agree. My only point is that I don't want excessive risk taking taking place with my payment system banks. That's it. Your 15 percent says, "OK, I'll protect it by making them put up the first loss piece of 15." Now they could find clever ways around how to deal with that, and you never know what's going to be off balance sheet and what's not presented. My guess is that 2,000 pages of Dodd-Frank created at least 2,000 potential regulatory arbitrages, and that the federal regulators will never be able to stop it, and the way you stop it for sure is you just say, "If you are going to be a payment system bank, if you are going to be a clearing bank, if you are in that business that is a public utility, you get treated like a public utility." Simple. That's what Glass-Steagall was.
Meltzer: Yes, circumvention is a problem. I agree that circumvention is a problem. I helped to write the Brown-Vitter bill and it says, "If you hold an asset, wherever you hold it, however you describe it, you hold 15 percent capital against it, and there's no risk adjustment." If you don't think that the asset is worth holding 15 percent equity against, sell it.
Tkac: Seriously, thank you very much for sharing your thoughts. The Atlanta Fed has a culture of open dialogue and unfiltered debate, and I think you've done a great job in helping us continue that culture. Thank you very much.
Zervos: Thank you.
Meltzer: Thank you, Paula.