Volcker on Volcker's Rule

[Sheilbh]

January 31, 2010
Op-Ed Contributor
How to Reform Our Financial System
By PAUL VOLCKER

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, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.

Aggressive action by governments and central banks — really unprecedented in both magnitude and scope — has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession.

Now the economy is recovering, if at a still modest pace. Funds are flowing more readily in financial markets, but still far from normally. Discussion is underway here and abroad about specific reforms, many of which have been set out by the United States administration: appropriate capital and liquidity requirements for banks; better official supervision on the one hand and on the other improved risk management and board oversight for private institutions; a review of accounting approaches toward financial institutions; and others.

As President Obama has emphasized, some central structural issues have not yet been satisfactorily addressed.

A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established "safety net" undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world's largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.

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. We need to find more effective fail-safe arrangements.

In approaching that challenge, we need to recognize that the basic operations of commercial banks are integral to a well-functioning private financial system. It is those institutions, after all, that manage and protect the basic payments systems upon which we all depend. More broadly, they provide the essential intermediating function of matching the need for safe and readily available depositories for liquid funds with the need for reliable sources of credit for businesses, individuals and governments.

Combining those essential functions unavoidably entails risk, sometimes substantial risk. That is why Adam Smith more than 200 years ago 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, governments have long provided commercial banks with the public "safety net." The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform.

The further proposal set out by the president recently to limit the proprietary activities of banks approaches the problem from a complementary direction. The point of departure is that adding further layers of risk to the inherent risks of essential commercial bank functions doesn't make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets.

The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally.

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 an elaboration of so-called Chinese walls between different divisions of an institution. The further point is that the three activities at issue — which in themselves are legitimate and useful parts of our capital markets — are in no way dependent on commercial banks' ownership. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a "level playing field" without clear value added.

Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be "too big" or "too interconnected" to fail. In fact, sizable numbers of such institutions fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers. 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 by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.

To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new "resolution authority." Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.

To help facilitate that process, the concept of a "living will" has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts.

To put it simply, in no sense would these capital market institutions be deemed "too big to fail." What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.

I do not deal here with other key issues of structural reform. Surely, effective arrangements for clearing and settlement and other restrictions in the now enormous market for derivatives should be agreed to as part of the present reform program. So should the need for a designated agency — preferably the Federal Reserve — charged with reviewing and appraising market developments, identifying sources of weakness and recommending action to deal with the emerging problems. Those and other matters are part of the administration's program and now under international consideration.

In this country, I believe regulation of large insurance companies operating over many states needs to be reviewed. We also face a large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed. Those are matters for another day.

What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out. My clear sense is that relevant international and foreign authorities are prepared to engage in that effort. In the process, significant points of operational detail will need to be resolved, including clarifying the range of trading activity appropriate for commercial banks in support of customer relationships.

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. They will argue that they themselves and intelligent regulators and supervisors, armed with recent experience, can maintain the needed surveillance, foresee the dangers and manage the risks.

In contrast, I tell you that is no substitute for structural change, the point the president himself has set out so strongly.

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. To do less will simply mean ultimate failure — failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future.

Paul Volcker, a former chairman of the Federal Reserve, is the chairman of the president's Economic Recovery Advisory Board.

[Sheilbh]

I found this Economist article useful on the subject:

Obama and the banks
Glass-Steagall lite
Barack Obama proposes limiting the activities of big banks

Jan 22nd 2010 | NEW YORK | From The Economist online
REUTERS

IT IS a fair bet that one of Barack Obama's new-year's resolutions was to rattle Wall Street. A week after hitting America's largest financial firms with a "responsibility" fee, to recoup up to $120 billion in bail-out losses, on Thursday January 21st the president proposed dramatic new curbs on their activities. Keen to show progress in at least one part of his agenda, especially after an election in Massachusetts stripped the Democrats of their super-majority in the Senate and put health-care reform in doubt, Mr Obama touted the plan as a way to cut the bloated giants of finance down to size and constrain excessive risk-taking with customer deposits. "Never again will the American taxpayer be held hostage by a bank that is too big to fail", he thundered.

The implausibility of that claim should not detract from the potential impact of the plan. Though not a full return to Glass-Steagall, the law that separated commercial banking and investment banking in the wake of the Great Depression (and was repealed in 1999), it is at least a return to its "spirit", as one official put it. Reflecting the possible dent it could put in profitability, bank shares tumbled, pulling stockmarkets down sharply around the world.

The first half of the plan concerns restrictions on the scope of activities. Banks that have insured deposits, and thus access to emergency funds from the central bank, would not be allowed to own or invest in private equity or hedge funds. Nor would they be able to engage in "proprietary" trading—punting their own capital—though they could continue to offer investment banking for clients, such as underwriting securities, making markets and advising on mergers.

The second part focuses on size. Banks already face a 10% cap on national market share of deposits. This would be updated to include other liabilities, namely wholesale funding. The aim is to limit concentration, which has increased greatly over the past 20 years, accelerating during the crisis as healthy banks bought sick ones. The four largest banks now hold more than half of the industry's assets.

These proposals will be wrapped into a broader set of reforms that is grinding its way through Congress. A bill passed by the House of Representatives, but not yet taken up by the Senate, gives regulators the right to limit the scope and scale of firms that pose a "grave" threat to stability. The new plan goes further, requiring them to do so. It is also more radical than the increased capital charges for trading assets proposed by the Basel Committee of international bank supervisors.

The administration had until now seemed content to shackle the banks with tougher regulation, including higher capital ratios, rather than breaking them up or limiting what they could do. But it has warmed to the thinking of Paul Volcker, a former Federal Reserve chairman and Obama adviser, who has long advocated more dramatic measures—indeed, Mr Obama dubbed the latest reforms "the Volcker rule". Intriguingly, the rethink was prompted as much by banks' behaviour over the past year as by their pre-crisis sins. In explaining their rationale, officials pointed to the fat profits some banks made in capital markets in 2009 while benefiting from state guarantees. On the same day as the plan's unveiling, Goldman Sachs reported better than expected results, thanks largely to outsized investment-banking fees.

With details yet to be hammered out, the plan's effects are hard to gauge. Commercial banks may be unfazed by curbs on trading. Most have already pared their prop-trading desks. JPMorgan Chase derives a mere 1% of its revenues (and 3-5% of its investment bank's) from such business. But having to divest Highbridge, a big hedge-fund firm, would be "horrible", says a JPMorgan insider. The bank thinks that may not be necessary since its capital is not invested directly in Highbridge's funds. But no one is sure.

Things could be trickier for investment banks that became bank holding companies during the crisis. Having built up its deposit base, Morgan Stanley would face a hard choice between remaining a bank and going back to being a broker that can trade freely. Goldman, which gets 10% or more of its revenue from prop-trading, will surely do the latter. That raises an awkward question: once it is cut loose from banking restrictions, and from Fed funding, would it not continue to enjoy implicit state backing? Would it really be allowed to fail if it blew up? Officials argue that other reforms, such as central clearing for derivatives, will make it easier to let such firms die. Convincing markets of that will be difficult.

Enforcement could be tricky, too. Regulators will struggle to differentiate between proprietary trades and those for clients (someone is on the other side of every trade) or hedging. Getting it wrong would be counter-productive: preventing banks from hedging their risks would make them less stable.

Moreover, the plan is unlikely to help much in solving the too-big-to-fail problem. Even shorn of prop-trading, the biggest firms will still be huge (though also less prone to the conflicts of interest that come with the ability to trade against clients). As for the new limits on non-deposit funding, officials admit that these are designed to prevent further growth rather than to force firms to shrink.

They may, in any case, be pointed at the wrong target. Curbing the use of deposits in "casino" banking is an understandable impulse, but some of the worst blow-ups of the crisis involved firms that were not deposit-takers, such as American International Group and Lehman Brothers. And much of the losses stemmed not from trading but from straightforward bad lending (think of Washington Mutual, Wachovia and HBOS).

That just leaves the question of whether the plan will make it through Congress. Scott Garrett, a congressman, captured the mood on the resurgent right when he branded the proposals "a transparent attempt at faux populism." Republicans are torn between distaste for government heavy-handedness and reluctance to be seen giving scorned bankers an easy time.

Mr Obama certainly cannot be accused of going soft on moneymen. In December, Mr Volcker complained that the reforms proposed so far had been "like a dimple." With his eponymous rule now on the table, he has changed his tune.

[Admiral Yi]

SHELFSHELFSHELF

I'm also curious how they will distinguish between market making and proprietary trading.

[citizen k]

SHELFSHELFSHELF

I'm also curious how they will distinguish between market making and proprietary trading.

And I'm wondering how it'll prevent banks from taking "too much" risk. Banks involved in hedge funds, by itself, didn't cause the financial collapse. It was bundling shitty loans into investment instruments.

[Martinus]

SHELFSHELFSHELF

I'm also curious how they will distinguish between market making and proprietary trading.

And I'm wondering how it'll prevent banks from taking "too much" risk. Banks involved in hedge funds, by itself, didn't cause the financial collapse. It was bundling shitty loans into investment instruments.

Even if that's true, this made them vulnerable to the collapse, and since they were gambling with money of pretty much everybody, this was why they had to be bailed out or they would drag everybody else with them.

[Sheilbh]

Even if that's true, this made them vulnerable to the collapse, and since they were gambling with money of pretty much everybody, this was why they had to be bailed out or they would drag everybody else with them.

I think this is important.  I mean the bailout didn't work because we stopped the collapse of a few investment banks; it worked because there was an implicit guarantee on the part of the government for the entire financial sector.  That was required precisely because the entire financial sector teetered.  So the goal should be to reach a point where investment banks that will engage in high-risk investments and speculation, can do that and can fail and can collapse without threatening the commercial banking sector which is essential for everyone.

[Admiral Yi]

Even if that's true, this made them vulnerable to the collapse, and since they were gambling with money of pretty much everybody, this was why they had to be bailed out or they would drag everybody else with them.

Since they were gambling with client money hedge fund operations made them not at all vulnerable to the collapse and had no relationship to the bail out.  The argument against in house hedge funds is conflict of interest, not systematic risk.

[The Minsky Moment]

Even if that's true, this made them vulnerable to the collapse, and since they were gambling with money of pretty much everybody, this was why they had to be bailed out or they would drag everybody else with them.

The argument against in house hedge funds is conflict of interest, not systematic risk.

Yes but Volcker tries to conflate the two.  Probably because the main victims of the conflict of interest are other big financial institutions and a jeremiad about the efficacy of ethical walls in investment banking isn't as compelling.

Hedge fund assets were just about the only assets the government did not guarantee in the late financial unpleasantness, so it seems more than a little odd to single those out if "moral hazard" is the rallying cry.

[Fate]

It's not odd. Democrats hate economic freedom and prosperity. Hedge funds too must fall under Obama's marxist heel.