If you watched the Senate Committee hearing with Paul Volcker yesterday, you witnessed Bob Corker making claims about things that never happened. Some people would call that a lie, and I'm not the only person that thinks so. Two other bloggers agree with me, Zero Hedge and Karl Denninger at Market Ticker who also wrote a piece on the hearing.
The rules Volcker wants to put in place are good, I am convinced of that. They are along the lines of what used to be in the Glass-Steagal act that was repealed by the Gramm-Leach-Bliley Act. You can Google that and find all the pertinent information. I won't dissect this any further because Zero Hedge and Karl at the Market Ticker have done a much better job than I could have.
What I will do is bring up another point - one that is a real sore spot with me - the damn media coverage of things like this. CNBC, if you watch them enough, will already know they are nothing more than shills for the banks. Anything good for the banks, they are for - even the bailouts. Of course when the auto companies got bailed out, they were beside themselves with contempt. Yet, when their parent company at the time GE, got their bailout money, they were of course ecstatic.
I don't care which side of the coin they are on with these issues, but at least be consistent. Of course being the capitalists they claim to be, they should be against ANY bailout, but they are not. They are when it fits their agenda. I must add as well, I don't really turn to them for opinions; I turn to them for NEWS. To bad I don't get much.
I watch them daily, and have for over a year as I trade throughout the day. I only do so for the breaking news and some of the information they provide; keyword being some. Rick Santelli, and a few others (Art Cashin, Mark Haines, Diana Olick, Mary Thompson to name a few) do a very good job reporting and asking some good questions to their guests. The rest are nothing but pump monkeys, and yes, they lie to us. That is NOT the kind of reporting I expect from a station who professes to be "The first in business news worldwide."
Perhaps worse, is their attempt to change public opinion, which many times they claim as populism. Is populism bad? Is something they are against, even if it's good for Main Street, flagged as populism because anything labeled as populism is bad? Who's the word cop here? I don't give a damn what they call it, if it’s good for the taxpayers of America - I'm all for it - and you can call it anything you want, even a turd. But of course CNBC, throughout the day, or since that hearing (even before actually) have done nothing but demonize it. Who's friken side are you on people? That's pathetic, wrong, disingenuous, and down right horseshit.
The only reason I watch CNBC instead of another channel is because I get feed though my trading software. I don't think they are worth the electric I would use watch them on my television. I have recently read their ratings are still going south, and I would hope so, and I’m glad. Anyone can put a bunch of puppets on the air daily and tell us to buy any and every stock known to man. They were recently bought from GE by Comcast, and I had hoped to see an improvement. Not. CNBC, I hope your ratings continue to fall, and I hope they fall as fast as our market crashed last year (which you didn't bother to warn anyone about - hear that Kudlow?)in the hopes that someday the convicts were no longer running the prison. We are in dire times in this country; we deserve the TRUTH - not a bunch of pump monkey's spewing lies for 14 hours a day. Hear that Comcast?
Showing posts with label Paul Volcker. Show all posts
Showing posts with label Paul Volcker. Show all posts
Wednesday, February 3, 2010
Tuesday, February 2, 2010
Paul Volcker's prepared testimony to the Senate Financial committee - 2:50 pm
You can listen here.
From the Wall Street Journal
By Michael Corkery
Paul Volcker is due to testify today at 2:30 p.m. before the Senate Banking Committee on his proposal to limit trading activities at commercial banks. Here is his prepared statement
STATEMENT OF PAUL A. VOLCKER BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS OF THE UNITED STATES SENATE WASHINGTON, DC
FEBRUARY 2, 2010
Mr. Chairman, Members of the Banking Committee:
You have an important responsibility in considering and acting upon a range of issues relevant to needed reform of the financial system. That system, as you well know, broke down under pressure, posing unacceptable risks for an economy already in recession. I appreciate the opportunity today to discuss with you one key element in the reform effort that President Obama set out so forcibly a few days ago.
That proposal, if enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities. In itself, that would be a significant measure to reduce risk. However, the first point I want to emphasize is that the proposed restrictions should be understood as a part of the broader effort for structural reform. It is particularly designed to help deal with the problem of “too big to fail” and the related moral hazard that looms so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the midst of crises.
I have attached to this statement a short essay of mine outlining that larger perspective.
The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions.
Those quintessential capital market activities have become part of the natural realm of investment banks. A number of the most prominent of those firms, each heavily engaged in trading and other proprietary activity, failed or were forced into publicly-assisted mergers under the pressure of the crisis. It also became necessary to provide public support via the Federal Reserve, The Federal Deposit Insurance Corporation, or the Treasury to the largest remaining American investment banks, both of which assumed the cloak of a banking license to facilitate the assistance. The world’s largest insurance company, caught up in a huge portfolio of credit default swaps quite apart from its basic business, was rescued only by the injection of many tens of billions of dollars of public loans and equity capital. Not so incidentally, the huge financial affiliate of one of our largest industrial companies was also extended the privilege of a banking license and granted large assistance contrary to long-standing public policy against combinations of banking and commerce.
What we plainly need are authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets. The first line of defense, along the lines of Administration proposals and the provisions in the Bill passed by the House last year, must be authority to regulate certain characteristics of systemically important non-bank financial institutions. The essential need is to guard against excessive leverage and to insist upon adequate capital and liquidity.
It is critically important that those institutions, its managers and its creditors, do not assume a public rescue will be forthcoming in time of pressure. To make that credible, there is a clear need for a new “resolution authority”, an approach recommended by the Administration last year and included in the House bill. The concept is widely supported internationally. The idea is that, with procedural safeguards, a designated agency be provided authority to intervene and take control of a major financial institution on the brink of failure. The mandate is to arrange an orderly liquidation or merger. In other words, euthanasia not a rescue.
Apart from the very limited number of such “systemically significant” non-bank institutions, there are literally thousands of hedge funds, private equity funds, and other private financial institutions actively competing in the capital markets. They are typically financed with substantial equity provided by their partners or by other sophisticated investors. They are, and should be, free to trade, to innovate, to invest – and to fail. Managements, stockholders or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system.
Now, I want to deal as specifically as I can with questions that have arisen about the President’s recent proposal.
First, surely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood.
Second, the functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult. As with any new regulatory approach, authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds.
Similarly, every banker I speak with knows very well what “proprietary trading” means and implies. My understanding is that only a handful of large commercial banks – maybe four or five in the United States and perhaps a couple of dozen worldwide – are now engaged in this activity in volume. In the past, they have sometimes explicitly labeled a trading affiliate or division as “proprietary”, with the connotation that the activity is, or should be, insulated from customer relations.
Most of those institutions and many others are engaged in meeting customer needs to buy or sell securities: stocks or bonds, derivatives, various commodities or other investments. Those activities may involve taking temporary positions. In the process, there will be temptations to speculate by aggressive, highly remunerated traders.
Given strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses would go a long way toward informing such judgments. For instance, patterns of exceptionally large gains and losses over a period of time in the “trading book” should raise an examiner’s eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements.
Third, I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a “customer”, i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. “Inside” hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same “inside” funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades.
I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses. But neither am I so naïve as to think that, even with the best efforts of boards and management, so-called Chinese Walls can remain impermeable against the pressures to seek maximum profit and personal remuneration.
In concluding, it may be useful to remind you of the wide range of potentially profitable services that are within the province of commercial banks.
• First of all, basic payments services, local, national and worldwide, ranging from the now ubiquitous automatic teller machines to highly sophisticated cash balance management;
• Safe and liquid depository facilities, including especially deposits contractually payable on demand;
• Credit for individuals, governments and businesses, large and small, including credit guarantees and originating and securitizing mortgages or other credits under appropriate conditions;
• Analogous to commercial lending, underwriting of corporate and government securities, with related market making;
• Brokerage accounts for individuals and businesses, including “prime brokerage” for independent hedge and equity funds;
• Investment management and investment advisory services, including “Funds of Funds” providing customers with access to independent hedge or equity funds;
• Trust and estate planning and administration;
• Custody and safekeeping arrangements for securities and valuables.
Quite a list. More than enough, I submit to you, to provide the base for strong, competitive – and profitable - commercial banking organizations, able to stand on their own feet domestically and internationally in fair times and foul.
What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services. Recurrent pressures, volatility and uncertainties are inherent in our market-oriented, profit-seeking financial system. By appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of very large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek.
You can watch the reply here.
From the Wall Street Journal
By Michael Corkery
Paul Volcker is due to testify today at 2:30 p.m. before the Senate Banking Committee on his proposal to limit trading activities at commercial banks. Here is his prepared statement
STATEMENT OF PAUL A. VOLCKER BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS OF THE UNITED STATES SENATE WASHINGTON, DC
FEBRUARY 2, 2010
Mr. Chairman, Members of the Banking Committee:
You have an important responsibility in considering and acting upon a range of issues relevant to needed reform of the financial system. That system, as you well know, broke down under pressure, posing unacceptable risks for an economy already in recession. I appreciate the opportunity today to discuss with you one key element in the reform effort that President Obama set out so forcibly a few days ago.
That proposal, if enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities. In itself, that would be a significant measure to reduce risk. However, the first point I want to emphasize is that the proposed restrictions should be understood as a part of the broader effort for structural reform. It is particularly designed to help deal with the problem of “too big to fail” and the related moral hazard that looms so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the midst of crises.
I have attached to this statement a short essay of mine outlining that larger perspective.
The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions.
Those quintessential capital market activities have become part of the natural realm of investment banks. A number of the most prominent of those firms, each heavily engaged in trading and other proprietary activity, failed or were forced into publicly-assisted mergers under the pressure of the crisis. It also became necessary to provide public support via the Federal Reserve, The Federal Deposit Insurance Corporation, or the Treasury to the largest remaining American investment banks, both of which assumed the cloak of a banking license to facilitate the assistance. The world’s largest insurance company, caught up in a huge portfolio of credit default swaps quite apart from its basic business, was rescued only by the injection of many tens of billions of dollars of public loans and equity capital. Not so incidentally, the huge financial affiliate of one of our largest industrial companies was also extended the privilege of a banking license and granted large assistance contrary to long-standing public policy against combinations of banking and commerce.
What we plainly need are authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets. The first line of defense, along the lines of Administration proposals and the provisions in the Bill passed by the House last year, must be authority to regulate certain characteristics of systemically important non-bank financial institutions. The essential need is to guard against excessive leverage and to insist upon adequate capital and liquidity.
It is critically important that those institutions, its managers and its creditors, do not assume a public rescue will be forthcoming in time of pressure. To make that credible, there is a clear need for a new “resolution authority”, an approach recommended by the Administration last year and included in the House bill. The concept is widely supported internationally. The idea is that, with procedural safeguards, a designated agency be provided authority to intervene and take control of a major financial institution on the brink of failure. The mandate is to arrange an orderly liquidation or merger. In other words, euthanasia not a rescue.
Apart from the very limited number of such “systemically significant” non-bank institutions, there are literally thousands of hedge funds, private equity funds, and other private financial institutions actively competing in the capital markets. They are typically financed with substantial equity provided by their partners or by other sophisticated investors. They are, and should be, free to trade, to innovate, to invest – and to fail. Managements, stockholders or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system.
Now, I want to deal as specifically as I can with questions that have arisen about the President’s recent proposal.
First, surely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood.
Second, the functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult. As with any new regulatory approach, authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds.
Similarly, every banker I speak with knows very well what “proprietary trading” means and implies. My understanding is that only a handful of large commercial banks – maybe four or five in the United States and perhaps a couple of dozen worldwide – are now engaged in this activity in volume. In the past, they have sometimes explicitly labeled a trading affiliate or division as “proprietary”, with the connotation that the activity is, or should be, insulated from customer relations.
Most of those institutions and many others are engaged in meeting customer needs to buy or sell securities: stocks or bonds, derivatives, various commodities or other investments. Those activities may involve taking temporary positions. In the process, there will be temptations to speculate by aggressive, highly remunerated traders.
Given strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses would go a long way toward informing such judgments. For instance, patterns of exceptionally large gains and losses over a period of time in the “trading book” should raise an examiner’s eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements.
Third, I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a “customer”, i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. “Inside” hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same “inside” funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades.
I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses. But neither am I so naïve as to think that, even with the best efforts of boards and management, so-called Chinese Walls can remain impermeable against the pressures to seek maximum profit and personal remuneration.
In concluding, it may be useful to remind you of the wide range of potentially profitable services that are within the province of commercial banks.
• First of all, basic payments services, local, national and worldwide, ranging from the now ubiquitous automatic teller machines to highly sophisticated cash balance management;
• Safe and liquid depository facilities, including especially deposits contractually payable on demand;
• Credit for individuals, governments and businesses, large and small, including credit guarantees and originating and securitizing mortgages or other credits under appropriate conditions;
• Analogous to commercial lending, underwriting of corporate and government securities, with related market making;
• Brokerage accounts for individuals and businesses, including “prime brokerage” for independent hedge and equity funds;
• Investment management and investment advisory services, including “Funds of Funds” providing customers with access to independent hedge or equity funds;
• Trust and estate planning and administration;
• Custody and safekeeping arrangements for securities and valuables.
Quite a list. More than enough, I submit to you, to provide the base for strong, competitive – and profitable - commercial banking organizations, able to stand on their own feet domestically and internationally in fair times and foul.
What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services. Recurrent pressures, volatility and uncertainties are inherent in our market-oriented, profit-seeking financial system. By appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of very large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek.
Sunday, January 31, 2010
NYT Op-Ed - How to Reform Our Financial System - by Paul Volcker
Full article here
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.
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.
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