Thursday, September 24, 2009

What Volcker Said

Commercial banks, taken collectively, are certainly systemically important. Their basic role is to provide vital basic services to customers – payment services, a safe depository for liquid funds, credit for individuals and businesses and financial advice.

As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.

Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks
. Paul Volcker

Speaking to the House Financial Services Committee, former Fed Chairman, Paul Volcker took dead aim at "too big to fail" and hit that nail on its head. Instead of designating certain financial institutions as "too big to fail" the US, he argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading.

In other words he is calling for the Banking Act of 1933 (a.k.a. the Second Glass Steagall Act), which separated commercial and investment banks, to be resurrected. With the benefit of hindsight, other things equal (which is never the case), had the Financial Services Modernization Act of 1999, which allowed consolidation of financial firms, not been enacted, the taxpayer cost to maintain a functioning commercial financial system would have been much less.

In econo-jargon, the benefits of economies of scale in consolidation are outweighed by additional costs associated with maintaining a functioning commercial financial system after the inevitable failures. This argument is predicated on the validity of Minsky's theory- capitalist finance, while a marvelous organizational tool, inevitably, over a period of generations, tends to systemic failure. If such is true, cost effective procedures for keeping vital financial functions operational, thus avoiding, inter alia, economic distress sufficient to expose a nation to invasion or substantial domestic poverty and discord (which lends itself to radical political solutions inconsistent with currently desired forms of representative government).

None of the above is an argument against more speculative financial practices. If you want to be a highly paid hedge fund manager who trades with high leverage and you don't want the Fed complaining about your risk management techniques- go ahead. If you succeed, great. If you fail, don't expect to be bailed out.

It seems worth noting that Goldman Sachs may well have failed had it not gotten the NY Fed to designate it a bank holding company (a sordid affair I opined on a few months back) and thus eligible for bail-out funds. This would not have happened if the old Banking Act was still in force. In other words, we could have exorcised the Goldman demon.

This seems to me a wise compromise. It doesn't prohibit investment, indeed, it might even lead to easier regulations on that sector. Yet, it considers commercial banking a vital part of America life, much as utility providers are, and thus government protected, and regulated. We don't want to lose the commercial flow of funds any more than we want to lose the flows of electricity or water. The phrase mature industry comes to mind, in particular the risk averse sense contained therein.

I was asked earlier today what I thought of Volcker's testimony. My reply, with my head nodding yes, "what he said."

Now we just need to wait for another financial collapse to get it passed.