I FIRST met Paul Volcker, 82, in the summer of 1986. He was then chairman of the US Federal Reserve System (Fed). I was a rookie Fellow of the Eisenhower Exchange Programme, whose chairman was President Gerald Ford.
Volcker was well known to me as the towering central banker (at 6ft 7in, not sure if he is the tallest economist around; late Harvard Prof Ken Galbraith was about there). He was better known as the daring but brutal inflation fighter of the late 70s and early 80s, at great cost in lost output and jobs.
He was kind to me when I visited him in his office; even gave me lunch. He was impressive, friendly and had time for a visitor (and fellow Harvard alumnus) who was completely at awe with what he does. We spent four hours together. We have since been in contact, off and on.
The Volcker Rule
Volcker is now back at centrestage, after retiring from the Fed some 20 years ago. This time, introduced as the “tall guy behind me”, President Obama proposed a “simple and common sense reform, which we are calling the ‘Volcker Rule’.” Essentially, the new bank reforms would ban proprietary trading and prevent banks from “owning, investing in and sponsoring” hedge funds or private equity ventures. The proposals are intended to curb the size and spread of the biggest US banks.
Volcker had pushed hard for such a version of the separation between commercial and investment banking, first brought into being by the Glass-Steagall Act of 1933, soon after the Great Depression. He considered this to be key in resolving the problem of banks getting “too big to fail” (TBTF).
Indeed, it challenges the status quo that institutionalises moral hazard and exposes governments to constant bailouts at taxpayers’ expense. Volcker wants to limit this guarantee. His proposal was first mooted more than a year ago.
The mayor and the gunslinger
Volcker’s Rule can be likened to separating a prosperous cowboy town’s operations into the mundane mayor-like activities (safe and less risky but unexciting) and the gunslinger-like operations (indulging in taking undue risks and speculation, e.g. credit default swaps or CDSs), including proprietary trading for own profit, quite unrelated to serving their customers.
This Rule would provide government backing for the unexciting but safe town-mayors, but not to the speculative gunslingers. Thus, getting banks out of the gunslingers’ business would eliminate the likes of Bear Stearns and Lehman Brothers from holding government hostage – a moral hazard every time. These gunslingers should be allowed to fail.
Volcker rationalised that banks are sheltered by the government because providing credit is critical to economic growth. As such, they should be prevented from taking advantage of the safety net to make risky investments. For Volcker, banks are there to serve the public and that’s what they should do. Other activities can create conflicts of interest. They create unnecessary risks.
Wide ranging support
Once called “big nanny” by Walter Wriston (chairman of Citicorp in the 70s and 80s), Volcker has a towering reputation worldwide. “He is brilliant, eminently logical and steadfastly devoted to his work,” said D. Rockefeller (Volcker’s boss in the late 50s). According to an old friend, Gerry Corrigan (New York Fed president when Volcker was Fed chief), whenever Volcker was criticised, he never “flinched” simply because “he’s a man of utter conviction and absolute integrity.”
That’s why Volcker’s ideas are widely respected. European Central Bank president Jean-Claude Trichet offered qualified support: it goes “in the same direction of our own position”. Along the way, he picked up other allies – notably John Reed (former chairman, Citicorp) and Stanley Fischer (ex-deputy CEO, International Monetary Fund or IMF).
Support has also come from chairman of the Financial Stability Board, the new president of the Swiss National Bank, and France’s Finance Minister: “It is a very, very good step forward.”
Mervyn King (governor, Bank of England) had been an early campaigner of a similar proposal to resolve the TBTF problem: “After you ring-fence retail deposits, the statement that no one else get bailed out becomes credible…That is the argument for trying to create firewalls.”
His version goes further than Volcker’s: He wants government to break up the big banks into “utilities” and “casinos” – the former are safe, the latter to live and die in the markets.
There is, of course, support from Prof J. Stiglitz (2001 Nobel Laureate in economics): “Banks that are too big to fail are too big to exist…That means breaking up too-important-to-fail (or too-complex-to-fix) institutions.” The latest being Harvard Prof N. Ferguson: “So far, there is only one credible proposal.” Since then, George Soros has also come on board.
Deciphering the Volcker Rule
The United States desperately needs financial reform. Ironically, as a result of massive government support, banks as a whole are now doing reasonably well. This contrast of strong finance and a weak jobless economy in the early stages of recovery makes the politics of reform easy to understand. But, unemployment looms large.
Voters in the United States feel betrayed by the banks and want to feel that their anger has been heard. Yet, voters cannot be sold on technicalities. The Volcker Rule (VR) has concerns in controversial technicalities.
The best insight I have read in deciphering the VR is provided by two of the London Financial Times’ best economic columnists, Martin Wolf and John Gapper. I have respect for Wolf, whom I have met occasionally at seminars run by Harvard’s Marty Feldstein at the National Bureau of Economic Research. Wolf raises three pertinent questions: are Volcker’s proposals desirable, workable and relevant?
Desirable? Of course. Surely, banks should not be allowed to exploit the government’s “guarantee” to make speculative investments with little economic benefits. The very idea of banks profiteering from activities from whose consequences they had to be rescued and of whose impact the public is still suffering, is despicable. Nevertheless, Wolf thinks the VR is not the best way to go.
Workable? Here many doubts arise. Where do you draw the line (and police it) between legitimate bank activities and activities “unrelated to serving their customers”. Various technical considerations begin to blur the line. Further, how is bank size to be measured? Definition technicalities get more complicated.
Relevant? Wolf argues persuasively that vast affiliated parts of the financial system which have evolved from deposit-taking are vital; and indeed represent well-coordinated component parts of the entire system. These have become so interconnected that the system operates as one integral whole. Then, there is “shadow” banking (institutions with promises to repay liabilities on demand), which is vulnerable to a “run” as well. The list extends to money market funds, finance companies, structured investment houses, securities dealers, etc.
Surely, this chain of shadow institutions can’t be ignored in any reform exercise. Ironically, during the crisis, banks’ investments in hedge funds, private equity and even proprietary trading were not at the “core” which went terribly wrong.
Gapper argues that “Volcker has the measure of the banks.” For the first time, he states: “A government is attacking the size and complexity of the over-mighty institutions.” Impractical? No way. Hedge funds and private equity can be readily hived off from banks with access to the Fed window and Federal Deposit Insurance Corp insurance.
Granted, the definition of proprietary trading can be technically tricky. But, in reality, banks know what a proprietary desk is. Indeed, Volcker assured US Congress that “bankers know what proprietary trading is and is not. Don’t let them tell you different…I don’t think it’s so hard.” He emphasised: “What I want to get out of the system is taxpayer support for speculative activity.”
Gapper didn’t think much of Wolf’s idea that the VR would not fit outside the United States where Europeans are not only wedded to the universal bank model but love big banks. Hence, there will be difficulties in international coordination of regulation. This is an over-reaction.
Gapper argues that the VR does not prevent the investment houses from – indeed, they are already taking – big risks. What is important is for the US system to be reformed and made stable. The VR would not curb innovation or stop hedge funds and private equity from making money. Curbs on very large financial institutions are compatible with – indeed, can stimulate – a thriving and stable financial system.
It is noteworthy that Volcker himself concedes that the proposals would not have prevented the debacles at American International Group and Lehman at the heart of the 2008 crisis. But he stated emphatically that not adopting the proposals would surely “lead to another crisis in the future”.
Can big banks really walk alone?
Both Wolf and Gapper agree that the VR is not perfect – its implementation needs sharpening. As I see it, serious bank reform is a global problem. Other central banks should offer ideas. It’s worth trying to forge reform that is smart and practical. Lest we forget, contagion risk and counterparty failure globally have been the main hallmarks of the crisis.
Human nature being what it is, I don’t think we have seen the last of “gung ho” traders and their quants who just want to drive profits. Right now such activity is already back to up profits in some big banks. Since we don’t (and won’t) really learn, the separation of commercial banking functions from such high-risk activities is what the VR is all about.
I gather that OECD (a developed nations group) has also been looking at options. One concerns structuring systemically important financial institutions (SIFIs) under a variant of non-operating holding companies on a global basis, as follows:
(i) Parent is non-operational – only raises capital and invests transparently in legally separate SIFIs;
(ii) Profits are flowed-up through parent to shareholders;
(iii) Parent not allowed to shift capital among subsidiaries in crisis and can’t request special dividends to do so. Such a structure allows for the separation of prudential risks and use of capital. In this way, regulators and investors can spot potential weaknesses. It creates a non-subsiding environment for the riskier business;
(iv) In the event of failure, the regulator shuts it down without affecting its commercial banking sister – obviating the need for even “living wills”. This offers an innovative, transparent way to achieve globally what both Volcker and King wanted but without being extreme.
Whatever the final outcome, a right balance needs to be struck between an appropriate size that’s conducive to benefit from purposeful diversification, and strong global competition to meet sustainable consumer demands at reasonable cost.
In the end, realistically, I can’t see how the VR or its variants, including what the OECD is working on, can really prevent another crisis, human nature being what it is. History is full of repeats where “greed” eventually overwhelms prudence and common sense.
Nevertheless, it could make one less likely, less often (we have had one every three years), and less costly if it did occur. To this, I think Churchill would have added: such a measure would make finance less proud but the industry more content.
Source: ● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time promoting public interest. Feedback is most welcome; email:
starbizweek@thestar.com.my.
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