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Sunday, January 31, 2010

Volcker: How to Reform the Financial System

Paul Volcker summarizes his ideas for reforming the financial system:

How to Reform Our Financial System, by Paul Volcker, Commentary, NY Times: President Obama 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform...
A large concern is the residue of moral hazard from the extensive and successful efforts ... to rescue large failing ... financial institutions. ... The phrase “too big to fail” has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.
As things stand, the consequence will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. ... That is why Adam Smith ... advocated keeping banks small. Then an individual failure would not be so destructive for the economy. That approach does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.
Instead,... the ... implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration ... as a key element of reform.
The further proposal ... to limit the proprietary activities of banks approaches the problem from a complementary direction. ... The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading... Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. ...
Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by ... walls between different divisions of an institution. The further point is that the three activities at issue ... are in no way dependent on commercial banks’ ownership. ...
There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority ... to limit their capital and leverage would be important... To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals ... point to the need for a new “resolution authority.” ... To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” ...
I am well aware that there are interested parties that long to return to “business as usual,” even while retaining the comfort of remaining within the confines of the official safety net. ...
I’ve been there — as regulator, as central banker, as commercial bank official and director — for almost 60 years. I have observed how memories dim. Individuals change. Institutional and political pressures to “lay off” tough regulation will remain — most notably in the fair weather that inevitably precedes the storm.

The implication is clear. We need to face up to needed structural changes, and place them into law. ...

Update: Edmund Andrews:

Volcker vs. Volcker?, by Edmund L. Andrews: Paul Volcker lays out his argument in the New York Times today for "Volcker rule'' -- President Obama's new proposal to rein in "too big to fail'' institutions by limiting the size of banks and keeping them out of riskier businesses like proprietary trading, hedge funds and private equity.
But those who suspect that the proposal is window-dressing for the more tepid approach favored by Treasury Secretary Tim Geithner won't get much comfort.
Volcker starts off well... He even invokes Adam Smith ... as a supporter for keeping banks small. But then there is this jolt:
That approach does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.
Huh? What about Obama's idea to limit the size of the banks, based on the size of their liabilities? Even if it was nothing more than a call to limit the biggest banks to their current size, where was that? Nowhere. Volcker simply pivots to the other proposal, on keeping banks out of prop trading.
I became even more suspicious by the way Volcker made only glancing reference to other key initiatives that could reduce TBTF -- namely, better capital requirements.
If you really want to rein in moral hazard and risk-taking associated with the implicit government backstop for huge institutions, then your most potent tool is to impose sharply higher capital requirements on the giants. Aligning the risks of size with much bigger capital reserves to offset that risk would be a huge disincentive for institutions to get as big as they possibly can. Structured properly, capital requirements could even induce banks to divest parts of their business before they become too big to fail.
But while there is constant lip service these days about tougher capital requirements, it is far from clear that the Obama administration wants to push that hard. And Volcker's rather off-hand reference isn't encouraging.
Volcker does make a spirited case for his other key structural proposal: prohibiting banks and bank holding companies from engaging in prop trading. But as the cliche goes, the devil is in the details and Volcker stays far away from any specifics.
Let me stipulate: I think Volcker sincerely wants to make big structural reforms, and he is clearly bolder than most of his colleagues. But it's much less clear what the Treasury and White House really want to do. Volcker is too polite to rail in public against the White House if he thinks the president isn't going as far as he himself would like. But that doesn't mean that doesn't mean that Obama's proposed rule is the same as the "Volcker rule."

I noticed the same thing, but let it pass without comment. More generally, I haven't understood why the left has so readily embraced Volcker -- after all he gained his reputation as a "hard money guy" by creating a recession to fight inflation and many people were quite unhappy about the loss of jobs at the time.

    Posted by on Sunday, January 31, 2010 at 12:33 AM in Economics, Financial System, Regulation | Permalink  Comments (86)


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